Debt funds are enjoying a “lender’s market” in a landscape where many large banks have retreated, which is creating more opportunities to do deals with higher-quality borrowers and lower risk, while still capturing enhanced returns.
AllianceBernstein is one firm that has experienced tremendous growth across its U.S. commercial real estate debt platform over the past three years. The team originated $5 billion in loans between 2020-2022—half of which occurred in 2022. “Looking ahead to 2023, we expect to remain active and capture increased deal volume from banks and other less capitalized alternative lenders,” says Peter Gordon, chief investment officer and head of U.S. Commercial Real Estate Debt at AllianceBernstein.
Debt funds have ample liquidity thanks to steady fundraising from investors that are continuing to gravitate to debt strategies. Investors like the risk-adjusted returns debt funds are delivering. Yields can run from low single-digits to mid-teens depending on the strategy. For example, Alliance Bernstein’s debt portfolios have consistently generated unlevered mid-to-high-single digit yields along with a strong emphasis on principal protection. “In today’s market environment, we believe returns for debt funds are expected to be higher when compared to 2019-2022,” says Gordon.
Across all risk profiles, debt investors are achieving wider margins, driven by capital markets headwinds, while base rates are higher due to the Fed’s focus on inflation reduction, adds Dean Dulchinos, head of debt portfolio management at AEW Private Equity. This environment affords investors the opportunity to achieve outsized returns while lending on collateral that has been repriced due to cap rate expansion and capital markets impacts. At the same time, leverage levels for new loan transactions are significantly below historical averages, often by as much as five to ten percent.
“As a result, lenders are enjoying better positioning power in the capital stack that could be compared with the capital markets following the GFC,” he says. “All of this taken together means that the risk-return tradeoff in the current market may be more favorable than at most other times in a typical cycle.”
The market has seen a flurry of new announcements in recent weeks. For example, Greystar Real Estate Partners LLC announced the final close of its $600 million Greystar Credit Partners III in December. And Dwight Capital and its affiliated real estate investment trust, Dwight Mortgage Trust, announced in January that it was launching a commercial real estate rescue capital fund to aid sponsors with equity shortfalls. The company said that it expects to deploy roughly $2 billion throughout 2023.
Although there seems to be a surge in interest in debt and credit investments lately, the reality is that capital has been flowing into private equity debt fund strategies for the past several years. In fact, fundraising among North American-focused debt funds slowed to $18.5 billion last year compared to the $26.3 billion raised in 2021, according to Preqin.
Yet some sponsors see the current constrained capital market as an opportunity to take advantage of fundraising tailwinds. “We’ve definitely seen a shift over the last nine to 12 months, especially as interest rates have increased, with both institutional and non-institutional investors that are looking for those higher returns,” says Gary Bechtel, CEO of Red Oak Capital Holdings. The company recently announced the launch of its latest Fund VI, which is a $75 million hybrid fund for CRE debt featuring two distinct products: a bond offering and a preferred units offering. The fund will focus on U.S. senior-secured, small-balance sheet real estate debt investments in primary and secondary markets.
Debt funds also are taking advantage of the contraction in the lending market with opportunities to deploy capital. “Our pipeline has done nothing but grow as interest rates have ticked up, especially as a lot of the floating rate lenders, debt funds and non-debt lenders, have seen their business curtailed pretty dramatically,” says Bechtel. The market has seen some shake-out among bridge lenders that were reliant on demand from floating rate product and business models that required bank warehouse lines or securitization in the CRE-CLO market—all of which are weaker in the current market. Red Oak also has added new products, including core and core-plus financing options, to satisfy demand from both borrowers and investors that are looking for lower risk profiles. “Even in a higher interest rate environment, we see an opportunity for growth,” says Bechtel.
Fund managers follow different strategies
Investors are finding plenty of choices with debt funds that are pursuing a variety of different strategies in terms of the types of loans and the property sectors they are targeting. Funds also are deploying capital across different risk strategies, including core, core-plus, value-add and opportunistic. Funds operating with higher return strategies tend to originate more subordinate or mezzanine debt, while funds with more conservative strategies are focusing on lower-leverage senior loans that have a senior position in the capital stack.
“In the U.S., we primarily focus on core-plus, construction-to-permanent, and value-add whole and subordinate loans,” says Dipak Patel, managing director of commercial real estate for AB Private Alternatives Business Development at AllianceBernstein. Its U.S. debt funds originate both fixed and floating rate loans across each strategy and offer investors the option of unlevered or levered investment vehicles. “The diversity of capital across our platform is what allowed our team to remain active during 2022,” adds Patel. Among the $2.5 billion in debt Alliance Bernstein originated across its US platform last year, 60 percent of that volume occurred in the second half of the year.
According to Dulchinos, debt strategies that can offer “clean” balance sheets free of legacy investments are focusing largely on providing capital to fill the gap being created from the estimated $500 billion of non-bank loan maturities coming due over the next two years. Meanwhile, lenders providing both acquisition and construction financing in senior and subordinate debt positions are finding opportunities in sectors that benefit from durable demand growth, particularly residential, logistics, and healthcare.
“While the lending market remains competitive in certain favored sectors, such as multifamily and logistics, the number of bidders across all transactions is significantly lower than it was a year ago,” notes Dulchinos. Regulatory pressures on bank lenders and capital markets pressures on debt funds, coupled with the burden of managing legacy loan portfolios, have reduced the number of active market participants and consequently the amount of available capital chasing deals, he adds.
Looking ahead to the coming year, debt funds may have to work harder to capture investor capital. Investors recognize that they do have many choices, and they also are more selective given the macro-economic challenges ahead. Debt fund managers will be looking to differentiate themselves through their strategies, track record and underwriting expertise, as well as a proven ability to select and manage assets successfully.