Commercial Mortgage Alert – Booming Debt-Fund Market Hits New Peaks

High-yield real estate debt funds are on the hunt for a record $75.9 billion of equity.

An annual review of the fund universe by sister publication Real Estate Alert identified a record 82 vehicles that primarily invest in debt, up from last year’s high of 74. The number of operators ticked up to 70 from 65 a year ago, matching the high-water mark set in 2019.

• “The space is booming,” said David Frank, chief executive of New York-based Stonehaven, a broker-dealer that works with roughly 20 real estate placement agents. “Low rates and high valuations in both public and private markets continue to make private credit an attractive option for investors. I don’t anticipate this will change anytime soon.”

The surveyed debt funds already have raised $46.8 billion of equity, according to the review. That’s up 4% from $45 billion in last year’s survey, but short of the record of $54.9 billion in 2019.

Real Estate Alert’s review tracks active closed-end funds that invest in properties, debt or both. They also must aim for a return of at least 10%, have or target U.S. investors, and have raised or seek to raise at least $50 million of equity.

This year’s survey captured 565 vehicles seeking to raise a record $490 billion. Of the 483 vehicles that aren’t focused on debt, 317 can invest in it to some degree. All told, a record 56% of the funds in the active universe are able to make debt investments. Dedicated debt funds accounted for 13.1% of the $358 billion of equity raised by active funds, according to this year’s survey. Among new funds added to the tally over the past 12 months, debt-focused vehicles accounted for 22% of capital raised — another marker of the sector’s growth. Interest in high-yield debt funds tends to pick up in times of market dislocation, as debt is more defensive than equity. And while the coronavirus pandemic that took hold a year ago this month has motivated managers to ask for capital, that has not yet translated to a slew of closings.

To date, funds have held closes on only 62% of the total aggregate equity goal — the lowest since 2013 and well below the 2019 peak of 80%. Part of that drop-off is due to the fact that many large managers spent the past few years investing the hoard they raised from 2017 to 2019.

The amount of equity raised likely will increase over the next year as managers including 3650 REIT, Brookfield, Kayne Anderson Real Estate, PCCP and Taconic Capital market 15 debt funds each with equity targets of at least $1 billion.

Another green shoot: Institutional interest in debt funds doesn’t appear to be slackening. In September, Blackstone held a final close on an $8 billion debt fund — the largest ever. And last week, Calpers disclosed it contributed $1 billion, or an unusually high 12.5%, toward that fund.

“Part of our thesis has always been that we expect debt to outperform equity in times of uncertainty,” said Kevin Cullinan, co-head of Mack Real Estate’s credit investment business. “We’ve seen that play out in 2020 and the beginning of 2021, which has supported continuing capital formation in the private debt market.”

Jon Brayshaw, a co-founder of New York investment manager Prime Finance, said that as nonbank lenders, fund operators compete with securitization shops by offering more flexible loan servicing. And with banks under increased regulatory pressure in recent years, he added that alternative lenders are better able to provide the types of higher-leverage, nonrecourse loans that many borrowers are seeking.

Brayshaw said he expects growing loan demand due to “pending maturities, necessary recapitalizations, increased numbers of workouts and restructurings.”

In addition, with expectations of a rosier economic picture in the second half of this year, property acquisitions are expected to pick up soon. In 2020, sales worth at least $25 mullion fell 35%, according to Real Estate Alert’s Deal Database.

“Any time you see a sudden disruption in markets, transaction volume declines for a period of time, but eventually pent-up demand builds,” Brayshaw said. “We think the economy is poised to recover quickly and that this will trigger greater, not less, demand for financing.”

Cullinan also expects a healthy lending market moving forward, for traditional transitional lending and for potential distressed deals. He said Mack has done more business in secondary markets over the past year, following the migratory patterns of people and business out of states such as New York and California to Texas and the Southeast.

“People are looking to take advantage of the distress, but the amount of capital in the system has prevented an onslaught of that distress,” Cullinan said. “So I think we’re bullish on the prospects of ‘ordinary course’ business while hopefully also being able to take advantage of some unique circumstances that may pop up over time.”

To be sure, debt funds are ready to lend. The annual tally found that the 82 active funds are sitting on $40.5 billion of uninvited equity, up 20% from last year’s survey and just behind the peak of $40.9 billion in 2019. Put another way, the active funds have 86.5% of their raised equity available — the highest since the review started tracking the metric 15 years ago.

The buildup of dry powder has lenders competing more fiercely with each other, pushing down coupons and returns. The active funds have a weighted average return goal of 12.1%, down 50 bp from last year and the lowest since the survey began tracking that data point in 2013.

The market remains bifurcated between haves and have-nots.

Just 14 active funds held final closes last year — the lowest tally since 2012. And the top five managers — Blackstone, Lone Star Funds, Goldman Sachs, TCI Real Estate, and Oaktree Capital — account for 45% of all raised equity in this year’s survey. That’s the highest since 2017 (52.3%).

That leaves small and mid-size managers competing for a smaller piece of the pie. Boots Dunlap, chief executive of Phoenix fund shop RRA Capital, said large investors are missing the chance to tap into the outsized returns of firms that traffic in higher-yielding deals. He added that too many large investors look at debt funds as a way to achieve beta, or manage risk, rather than generate high returns.

“Since it’s just beta they’re trying to achieve, they’d rather get beta from an institutional brand than a smaller shop,” Dunlap added. “It’s frustrating.” Still, Dunlap said he’s hopeful that more limited partners will broaden their horizons in the next year. There’s a “thawing of the fear to make a mistake,” he added. “I see institutional allocators and chief investment officers, for the first time since before Covid, being willing to … take a chance and add new managers.”

Vehicles in the Real Estate Alert survey are considered active if they are still raising capital or if they already have held final closes but have invested less than 75% of their equity. Each year, a rotating group of funds is counted.

Of the 82 debt funds, 65 invest or plan to invest solely in the U.S., eight focus only on non-U.S. plays, and the remaining nine have a global strategy.

The review classifies funds as debt vehicles if they intend to invest at least half of their equity in the origination of loans or in the acquisition of loans or debt securities. Funds are included if they raise capital at least partly from U.S. investors or invest mostly in U.S. commercial real estate. Joint ventures, separate accounts, and open-end funds are excluded.