The real estate debt fund market has exploded in the past decade, with $301 billion raised, data from affiliate title Real Estate Capital USA shows. Although fundraising has dipped somewhat since the peak of 2017, when 114 funds closed for $43 billion in aggregate, there were a considerable 198 real estate debt vehicles on the road as of 1 January, targeting a combined $51 billion.

Fundraising first hit double figures in the wake of the global financial crisis. “Post-GFC, major changes in financial regulation aimed at preventing another economic downturn restricted bank lending practices and allowed for the proliferation of real estate debt funds,” says Justin Guichard, managing director for real estate debt and structured credit strategies at Los Angeles-based manager Oaktree Capital Management.

“Loans with characteristics that fall outside today’s bank lending practices may offer higher returns, providing opportunities for real estate debt funds to earn an attractive yield for providing this liquidity to the market. As an ability to create large, diversified portfolios is viewed attractively by investors, and holistic financing solutions are valued by borrowers, alternatives firms have been successful at raising and deploying ever larger fund vehicles, giving more access to the asset class than ever before.”

“Real estate credit is one of those asset classes that can serve a number of different purposes,” says Isabelle Brennan, senior director in the global credit solutions division at CBRE Investment Management. “It offers bond-like characteristics, which means it can work as a fixed-income substitute, but it also has underlying real asset security, so it is familiar to real estate equity investors.”

Meanwhile, credit can represent an efficient way of deploying capital, as transaction costs are typically far lower than for equity. From a manager’s perspective, there is an excellent cross-selling angle: the borrower base is identical to the counterparties on the equity side, so adding debt to the product mix allows them to broaden the conversation.

But the real advantage of credit, of course, is that additional layer of downside protection. “It provides excellent risk protection in cyclical and volatile markets, as has been evidenced over the past few years,” says Roland Fuchs, head of European real estate financing at Allianz Real Estate. “Investors are able to remain active in real estate, but in a more resilient manner.”

Indeed, early-intervention mechanisms have served the industry well. Guichard says: “One of the reasons that the real estate sector has largely weathered the covid storm is the regulatory environment created in the aftermath of the GFC, which forced market participants to reduce risk taking, and therefore restrained the irresponsible real estate lending practices that contributed to the prior crisis.”

Meanwhile, that added downside resilience comes at only a modest discount. Cap-rate compression has reached a point where it can be challenging for equity managers to produce a current return. “In that context, an allocation to credit services the dual objectives of delivering attractive current yield with reduced volatility, owing to a more senior position in the capital stack,” says Todd Sammann, head of the Americas credit division at CBRE Investment Management.

Not only has the real estate credit market grown dramatically, but it has also become more nuanced. Ten years ago, the scope of available debt product was binary. “Today, the offering is much wider, both in terms of geography and product,” says Fuchs. “There are pan-European funds rather than just single-country funds, and there is a far greater offering in the mid- and low-investment-grade space, which is equivalent to core, core-plus and value add on the equity side. That mid-risk market just wasn’t available before.”

There is also diversification in terms of investment themes. Today, you can find a specialist debt fund focused on almost anything – hotels, logistics, retail, established assets, refurbishment. The choice is now comparable with the equity markets. Of course, some of those products are faring better than others; the pandemic caused a violent shift away from traditional bricks-and-mortar retail, for example, and ushered in an expanded set of products.

“This shift sustained the demand for industrial space, the new darling category of the real estate market,” says Guichard. “Life sciences, data centres, self-storage and apartments were also tagged as covid winners.”

From a credit standpoint, the life sciences sector is particularly attractive due to long-term leases, favourable industry trends and the attractive credit profile of well-capitalised tenants. This has created a spate of opportunities to finance the repurposing of offices. Banks and life insurance companies have supported this trend, although debt funds tend to be competitive in development or redevelopment situations.

Out-of-favor sectors include office buildings, particularly commodity or older office buildings lacking modern amenities and safeguards, which have suffered as remote working has become a standard component of the employee experience.

The pandemic also led to an immediate tightening of credit standards, with some lenders effectively ceasing to provide capital to certain markets. “This left many borrowers with few options to finance high-quality but out-of-favor assets such as resort hotels, recently constructed office product and residential condominiums, and led to a massive spike in credit spreads, which act as a real-time indicator of the relative risk of certain asset classes,” says Guichard.

Building conviction

This, of course, generated substantial risk-adjusted returns for credit investors who moved forward with conviction during such uncertainty. While the private loan market is typically less efficient due to its relationship-based nature, in the midst of forced selling, the traded-securities markets such as CMBS, CRE and CLOs provided broad opportunities for investors.

“The office sector has taken a beating during the pandemic and many lenders appear to have redlined the sector entirely,” says Sammann. “But while some form of work from home is clearly here to stay, workplaces will also have an important role to play going forward. The challenge, and the opportunity, is to identify the combination of office attributes that will attract the lion’s share of tenant demand and investor capital going forward. Meanwhile, a lack of competition means we can generate greater returns through higher coupons and drive more robust loan structures than in other sectors.”

Infrastructure debt

Infrastructure debt is increasingly viewed as an important component of many investors’ real assets portfolios.

“The amount of capital raised in infrastructure debt each year has more than quadrupled over the past decade,” says Kit Hamilton, co-head of Macquarie Asset Management’s private credit team. “Furthermore, not only has investor appetite grown, but it’s also shifted from investment grade to sub-investment grade, as well as into different jurisdictions as investors have less of a home bias, and as global markets mature.”

Meanwhile, the supply side for this asset class has been buoyed by factors including regulation requiring banks to hold additional capital against its mortgages, derivatives and securitisation assets, and the rationing of capital among internal business units, says Andrew Jones, QIC’s head of private debt. “These actions by the banks have left a gap which non-bank lenders are now filling to meet institutional investor demand.”

That demand is being driven by investor appetite for defensive income streams with strong yield, particularly in this lower-for-longer environment. “Infrastructure debt offers the advantage of access to investments with contracted or regulated cashflows, target assets providing essential services, stable earnings streams, high barriers to entry and a developed markets focus,” says Jones.