Interest eclipses waning returns for US debt funds

Investors still pile in despite lack of distressed debt opportunities, writes Al Barbarino

Despite falling returns and fewer opportunities to buy into distress at home, US investors are still keen on real estate debt funds – in fact interest has increased in recent quarters.

Data compiled by Real Estate Capital parent company PEI Media Research & Analytics shows that of the 10 largest global real estate debt funds investing, one hit its target and nine surpassed theirs. The top 10 funds raked in more than $47bn, nearly 17% over the aggregate target.

The most recent example is Colony Capital’s latest Distressed Credit and Special Situations Fund (CDCF) III, which targeted $1bn but is significantly oversubscribed above its hard cap of $1.2bn, with Colony turning away $400m in commitments.

“There’s been a huge consolidation in the fund business, just like the banks,” says the head of an investment adviser that manages equity funds focused on debt strategies. “The top 10 real estate sponsors are raising most of the money; that’s why the top funds are going well over their targets. Today’s investor psyche is that bigger is better.”

Deep market for debt funds

Michael Riccio
Michael Riccio

“The market for debt funds is the deepest I’ve seen in 30 years,” agrees Michael Riccio, a senior managing director with CBRE Capital Markets. But in the US, he adds: while “people like to talk about distress, it’s more an exception than the rule”. Hence many of the latest vintage of US funds have a heavier weighting to Europe (see table).

Though harder to find, distressed debt offers returns “as high as opportunity funds, at 15-20%”, says Ed Schwartz, co-founder of ORG Portfolio Management. “A low-risk fund might have 5-9% returns, depending on the real estate quality, loan-to-value level and where you are in the capital stack.”

However, US spreads have contracted and returns dropped across all debt strategies, not just distressed loan buying. “They aren’t getting the huge premiums they were six to 12 months ago, due to competition and abundant capital,” says Riccio. “Spreads on very low LTV debt for core assets are compressing; higher LTV mezzanine and bridge spreads are compressing as well, while in the middle, spreads are stabilised.”

But heavy competition has some debt funds (and their investors) “taking on more risk than they should relative to the returns,” Schwartz warns. “We’re very mindful of that and want to protect our clients from it.”

In the US, real estate debt investors and managers are targeting funds underwriting specific, stable real estate assets and only viable distressed assets, which are few and far between, to protect against capital losses.

Funds lending against transitional assets with a lot of upside – condo conversions, half-leased office buildings etc – are still prevalent, if not gaining popularity. For example, Blackstone Real Estate Debt Strategies is targeting such opportunities.

REC 11.14 - table p29Good absolute returns

“We’re lending at a discount to value, we get to underwrite market conditions and we only pick deals that fit our philosophy,” says Mike Nash, head of the group. “The result for investors is a relatively low volatility return prospect, current income focus, capital preservation and pretty good absolute returns in a low-interest-rate environment.

“Distress is not present in the US market,” he adds. “In Europe, systemic economic issues make the market more distressed.”

Investors are looking elsewhere to find the structures and risk-adjusted returns US distressed funds once provided, whether through alternative investment vehicles, special accounts or debt funds investing in assets abroad. Some investors have all but cut real estate debt funds from their strategies and formed new ones.

Greg Spick, real estate portfolio manager for UPS Group Trust, says real estate debt funds “need to shine” to justify investing in them, and right now they do not. Of the trust’s $30bn of assets under management, real estate accounts for nearly $2bn, only $400m of which is listed and unlisted debt.

“I’ve not been able to find a lot of real estate debt funds that work because the fees and the risk aren’t justified,” he says.

“This has led me to seek debt and find deals that are really off the run,” he adds. “I’ve been able to replicate a lot of debt stuff very efficiently and at a better cost basis in the public markets.”

 UPS Group Trust believes US debt no longer pays off

While Greg Spick, real estate portfolio manager for UPS Group Trust, isn’t opposed to investment in real estate debt funds, he says the current risk environment has led him to seek alternatives.

“By the time you work in the fees and the structures and really figure out what you’ve got on that fund, it needs to shine relative to other opportunities, “ he says. “The economics have to get better from my perspective. I need to find strategies where the risk profile makes sense. Debt is a very aggressive space now and a lot of people are looking to put debt on. But doing a debt deal is not a layup. It should be, but it’s not right now.”

Spick cites CMBS as an example of an “aggressive” market. “It’s pushing underwriting and everything else,” he says. “It’s not far off 2006 standards. People are looking for return wherever they can get it, so if something says it’s an 8% cash deal, people starved for yield like that. But the problem is how do you get that 8%?”

Public-market vehicles can “replicate” what debt funds offer, providing an equivalent return on a lower cost basis, Spick says.

“For example, one listed real estate company [I invest in] has preference shares. It’s basically unleveraged and I can buy it at a 6% return today. So if I can buy an unleveraged company at 6, that’s a pretty attractive return on a risk-adjusted basis,” he says.

However, he has invested in a real estate debt fund offered through Mesa West. “It’s a pretty plain vanilla fund,” he says. “Mesa focused on senior positions in that fund and that’s why I thought it was attractive. It works really well for me, but in general most of the products out there do not fit.”

ORG targets low-risk debt opportunities

ORG Portfolio Management advises large US pension funds on their real estate investments in public and private equity and debt. Its clients include the Texas Municipal Retirement System, Maine Public Employees Retirement System, Kentucky Retirement System and Santa Barbara County Employees Retirement System.

“We believe debt can be an attractive alternative to equity and in those cases we incorporate it into our world of investments,” says ORG co-founder Ed Schwartz. “Our clients have been interested in debt and have been active players, but we’re mindful that the returns have dropped. We make relative judgments, so debt has come to be lower-
returning, but so has equity, maybe more so.”

On the low-risk end of the spectrum, Schwartz’s team simply look for opportunities where there are “very low probabilities of capital loss. You give up the upside so you have to be careful not to have any losses.”

Schwartz says that “really good US distressed opportunities that can be worked through and capitalised on, with attractive risk-adjusted returns” are drying up, “but there’s a lot of good European opportunities.”

He is also concerned that some investors are stretching for yield and going high up on the loan-to-value scale, “taking much more risk than they should, relative to the returns.

“We worry about 80-85% loan-to-value ratios on a hotel, which can be pretty risky,” he says. “I think we’re getting toward 2005 and 2006 kind of pricing, but not quite 2007. We’re seeing some real estate exuberance.”