The real estate debt landscape in the United States has changed dramatically since the 2008 financial crisis. Whereas banks and government enterprises were the unquestioned dominant players in property lending before the Lehman Brothers implosion, 10 years later private equity funds have emerged as a significant source of capital. The $18.9 billion raised for US private debt strategies during that time is impressive, especially considering the state of the market before the collapse.

“Real estate debt as an asset class for investors really didn’t exist until after 2008,” says William Lindsay, co-founding partner at US fund manager PCCP. The firm is one of the few that can claim to have invested in real estate debt even before the crisis hit, albeit using methods other than private funds at that time.

Lindsay explains that the market was largely overshadowed by the over-leveraged financial institutions, meaning his team had to find creative ways to partner with them. It was only after the crisis that a space formed for private real estate debt funds.

Since 2010, the asset class has grown in both capitalisation and acceptance among the investor community. There are an increasing number of successful funds in the US market, and even more if multi-regional funds run by the likes of Blackstone are included. Indeed, JLL’s head of funds advisory for the Americas, Jerry Cain, says he has been surprised by the volume of capital flows into US property debt in the past 36 months.

“Post-crisis and a few years after, debt was a bad word; but as it is still widely accepted that the banks are under restrictions and cannot do some of the traditional lending, there is more of a need for the private debt space,” he says. “From a limited partner perspective, debt is now a more widely accepted asset class in a fund structure, complementing their equity strategy.”

Although global real estate debt fundraising saw a precipitous 48 percent drop worldwide in 2018 – the lowest fundraising for real estate debt globally since 2011 – the US saw only a 29.6 percent drop year-on-year, even when the large multi-regional funds, such as Goldman Sachs’ record-breaking $4.2 billion Broad Street Real Estate Credit Partners III, were excluded. In fact, given that 2017 was the most successful fundraising year on record, with almost $9.9 billion raised, the 2018 downturn is moderate compared with the 46.5 percent drop in 2014, according to fundraising data from sister publication PERE.

Whatever the numbers may say about the past decade, the future of this young market is hardly set in stone. Investors and managers alike must consider whether private equity real estate debt fundraising is just a temporary opportunity to sustain the market while bank lending gets back on its feet, or whether the industry will evolve to remain relevant.

Increasing acceptance of a shiny new asset class has led the US real estate debt space to become crowded – not just in deals, but also in fundraising. Cain knows of other equity sponsors, such as hedge funds, trying to take on some debt origination strategies in real estate, and more managers adding it to their traditional equity strategies.

“The senior loans market has really exploded,” Lindsay says. “[PCCP] used to be one of just a handful of real estate debt funds out there, and today we have about 20 to 30 competitors.”

What used to not even be considered its own asset class is now recognised as a strategy between fixed income and real estate, he explains. Real estate debt has become popular on every level – from mezzanine to REITs to private structured deals – and everyone seems to want a slice of the pie.

One factor contributing to this crowding tendency is returns compression in more traditional real estate investments. Most opportunistic funds in the US are now offering approximately 15 percent returns, while real estate debt is not far behind with 10-11 percent on average, with some funds offering as high as 13 percent. With debt funds offering much better downside protection, it seems a logical choice.

“Many equity funds and private investments have seen a lot of pressure on returns, so on a relative value basis [real estate debt] is attractive,” says Peter Weidman, global head of real estate credit at the Goldman Sachs Merchant Banking Division. “We’ve seen in past cycles, and we’re definitely seeing it now: the compression on spreads, pressure on yields, pressure to deploy capital.” He adds that this pressure is not unique to private funds.

Cain also says opportunistic deals in the US are harder to come by at this point in the cycle. In order to chase higher returns, some US LPs are becoming more open to non-gateway but institutionalised markets they would not have considered 10 years ago. Third- and fourth-tier cities like Birmingham, Alabama, and San Antonio, Texas, are getting investor attention. However, when LPs take that kind of risk, protecting their investment becomes a high priority.

“Compared to other available real estate investments, there are a lot of defensive characteristics to our kind of investing, especially later in the investment cycle,” Weidman says. “You can have a deterioration in [property] value, and still recover the full amount of your principal.”

In fact, some investors are so keen on this kind of real estate investment that they are increasing their direct investments, he adds – becoming competitors to the debt funds themselves.

International investors have also made a big splash in the market, Cain says. The tens of billions of potential investor dollars pouring into the US market would be enough to make many fund managers salivate, and they have not neglected to take advantage of the opportunity. PCCP had only one foreign investor in its 2012 vintage fund, PCCP Credit V, but in its most recent PCCP Credit IX, it accounted for 30 percent of the vehicle’s $1.25 billion total capital.

There is another reason international investors in the US gravitate towards debt: tax structure. According to Lindsay, the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) requires a 30 percent withholding on equity investment returns. But for debt investments, that is reduced to as low as 10 percent of the total returns, which makes returns for equity and debt investments almost neck-and-neck – maybe 10.5 percent versus 9 percent. The consequent interest of international investors combined with that of US investors has led to a market “flush with capital,” Lindsay says, which might be worrying to those who remember the pre-crisis real estate market.

Defensive posture

Generally, however, investors are not overly worried about another big crisis in real estate debt, even if they know that price corrections are on the horizon. In fact, planning for corrections in the market is what will prevent another real estate crisis in the country, some argue. Cain points out that investors in real estate debt have become savvy and are keeping an eye on policies or major trends that warrant caution. Overall, he has been impressed by their caution and rigour as they foray into this new asset class, with multilayered due diligence taking as long as six months in some cases.

“Even since we raised our first fund [in 2009], the investor base has become more educated on the strategies within debt,” Weidman says. Over time, investors had to become more sophisticated on equity investments, understanding the many different strategies and risk-return profiles in the various fund types and asset classes. “And now, I think we’re starting to see more of that kind of differentiation and understanding in the investor base on the debt side,” he explains.

It is beyond cliché to talk about the importance of track record for fund managers, but in US real estate debt it takes on a whole new meaning: with the disaster of 2008 fresh in most investors’ memories, there is a lot to be lost. Even with the new entrants to the market, the fund sponsors need to have proven their strategies through downturns, Cain says, which means only the high-quality sponsors are being capitalised at this point in the cycle.

“There is always concern about risks, and that’s why LPs are so meticulous in their underwriting,” Cain says. He finds that investors are looking for flexibility, quality and “one-stop shopping” – a new pattern where LPs want a fund manager they trust which can “take all their capital stack in one go, providing the senior and the mezzanine for real estate debt”. But every investor’s idea of risk is different, and they check new investments at the portfolio and fund level before committing.

Lindsay: “The senior loans market has really exploded.”

“In real estate, everyone touched the stove and got burned in 2007-08,” Lindsay says. “They survived, but they still remember it.” He recalls investors asking detailed questions about what PCCP learned from the crisis, about their credit process, and whether the firm has “thought through everything that could possibly go wrong”.

“Investors really appreciate that we found something that works and stick to it,” Weidman says. He hears concerns from investors about funds taking more risk and trying different strategies to get the same or higher returns, but that is not what these investors want from their real estate debt investments – they want a consistent strategy that they can rely on for steady returns, especially because in debt investments there is limited upside.

“[LPs] want to understand that there is limited downside – they already understand the limited upside,” Lindsay concurs.

Looking ahead

Even if the number of managers levels out over time, fund managers and analysts alike believe real estate debt funds are here to stay. Cain sees the past two years as the second wave of real estate debt fundraising and believes 2019 will be a crucial year for determining how the US market will shape up. JLL’s placement agent business is itself banking on the continued success of this market by looking for a real estate debt fund manager to partner with.

“I think we’re far enough into the cycle, there are enough structural changes in the banking system, and enough investor demand for this to be a permanent shift in the landscape,” Weidman adds.

The fact funds can react to investment opportunities quickly and structure their loans creatively – in ways most banks simply are not doing anymore – is a significant draw for investors, he explains. “If we were going to see that change back to traditional lenders dominating this space, we probably would have already seen it happen.”

Lindsay adds that some tactically minded investors are just in real estate debt to replace core investments temporarily as prices go up. “But my experience is once we show them what we can do in real estate debt, investors like it – and I don’t think we’re going to lose those investors.”

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