Real estate debt faces a challenging year

Once known as a predictable, stable and easily modelled asset class, real estate has seen a tumultuous start to the decade that has thrown doubt on many established investment philosophies.

The challenges began with the black swan event that was covid-19, something few investors could have predicted, and its fallout has turned many aspects of the real estate industry on its head.

As if that was not difficult enough for real estate investors, inflation has jumped in the aftermath of the pandemic and this of course led to a rapid increase in interest rates as the ‘lower for longer’ era came to an end.

While credit providers are often insulated from market volatility thanks to being secured against a hard asset, the health of the industry ultimately relies on financial sponsors and developers, so it is impossible to escape the fallout of these seismic macroeconomic shocks, even for private credit funds operating in the sector.

Private Debt Investor takes a look at some of the biggest factors affecting real estate credit funds as 2024 gets into its stride.

Tough for equity (and debt)

Much as in the wider corporate debt world, private credit in real estate remains highly dependent on equity investors to source deals, and figures show that private equity real estate fundraising is struggling.

Research from affiliate title PERE found that fundraising from Q1 2023 to Q3 2023 was down by 35 percent compared with the same period in 2022, with $92.8 billion raised by 139 funds. Furthermore, PERE estimates that if the fundraising trends seen in Q1-3 continued into the final quarter of the year, then total capital raised in 2023 would be the lowest recorded since 2012.

With fundraising for equity at its lowest point in more than a decade, there will likely be fewer deals taking place. This means a reduced demand for financing and will ultimately impact private credit funds by making it more difficult to deploy their own capital. Equity providers are also looking at a market where loan-to-value ratios are becoming more conservative and the cost of covering interest payments is increasing, all of which means they will need to put more equity into their deals, further stretching a pool of capital already restricted due to the fundraising slump.

“We have this core sector that is no longer performing in the way we would expect from a core asset”

Vincent Nobel,
Federated Hermes

Real estate debt funds are seeing an even more significant reduction, with PDI figures showing the first nine months of 2023 saw just $18.5 billion of capital raised across 25 funds, down 50 percent compared with the same period in 2022 – though that was a record year for real estate credit fundraising. However, this is also considerably lower than seen in any comparable time period since 2018. The sharp decline in the number of funds raised reflects a trend seen elsewhere in private credit, where fewer managers are raising larger funds while smaller vehicles struggle.

Consequences of covid

One of the most immediate impacts of covid on the real estate sector was the sudden and unexpected fall in demand for office space. With many employees working from home during the pandemic and a more flexible attitude towards office working persisting since then, the once strong and dependable demand for core office assets in city centres suddenly tailed off.

“The office sector is really struggling to find its new normal,” says Vincent Nobel, head of asset-based lending at investment manager Federated Hermes. “We have this core sector that is no longer performing in the way we would expect from a core asset.”

The proportion of funds focusing on core asset investment has declined significantly in 2023, making up just 1 percent of capital raised, according to PERE, down from 6 percent in 2022. Meanwhile, the proportion of opportunistic funds has increased from 32 percent in 2022 to 45 percent in 2023, indicating more investors are looking for a flexible approach to a market suffering from stress.

Industry has also suffered both from the fallout from covid, which saw major difficulties in accessing materials as the pandemic severed supply chains around the world, while Russia’s invasion of Ukraine in early 2022 caused energy prices to spike.

PERE’s figures show that an increasing number of real estate funds are now focusing on multifamily residential property, which in the first nine months of 2023 accounted for 56.7 percent of capital raised for sector-specific strategies and 30 of 47 funds.

Refinancing wave approaches

With loan durations typically between three and five years, the real estate credit sector will begin facing a major test this year, with many loans due to be rolled over for the first time since covid-19 hit.

“The wave of refinancing is a real thing, but for the majority of credits which are fundamentally good, then they should be able to either refinance now or extend their term until conditions improve and so a lot of it will go away of its own accord,” says Nobel.

“Where you’re going to have more difficulty is cases where you took on an asset which had interest coverage of say 1.3x a few years ago, but now rates are much higher and it might be more difficult to get the rent you need.”

He said in cases where the underlying asset is good quality, equity sponsors will likely step in with cash to alleviate such issues. However, for more challenging assets, particularly less desirable office space, equity holders may have to take the pain and lenders will be left holding an asset of questionable value.

While the environment for real estate investment is likely to remain challenging in the short term, credit fund managers remain relatively upbeat about longer-term prospects. Slowing inflation figures in recent months have prompted central banks to pause rate rises and there is a growing sense that rates will be cut this year, reducing pressure on borrowers and their tenants and improving interest coverage.

Fundraising may have slowed too,  but it’s worth remembering that both equity and debt funds are known to have built up a large amount of dry powder during the long years of low interest rates. The firepower to do deals is there, and if market volatility begins to calm later in 2024 then it is more likely that buyers and sellers will be able to agree on prices once again.

Real estate credit funds will continue to benefit from bank retrenchment in the sector, much as we’ve seen in the corporate lending world. Even in times of low deal activity, the reduction in bank finance should enable funds to continue selecting the best assets in the market.