The growing demand from institutional investors for US real estate debt has sparked a proliferation of new funds and strategies

The market for commercial property debt no longer consists primarily of senior mortgage loans on high-quality office and multifamily assets in gateway cities with impeccable economic credentials. Continuing low interest rates have fuelled an historic search for yield, driving capital into alternative investments. One of the most popular is commercial property debt instruments, which offer steady income streams and downside protection of principal value in proportion to the seniority of a given loan in an asset’s capital structure.

Investment managers have developed a variety of highly focused strategies that strive to deliver precious income to investors without gobbling up their risk budgets. Many of the lenders deliver debt capital to borrowers through tailored credit products that reflect the risk-reward profile of pension funds, who must keep one eye on their liabilities even as they seek the best available income returns.

However, commercial banks, which are traditionally the main source of loans for property assets, have been tightening lending standards, allowing non-banks to step in to make loans.

Property debt has become the next ‘big thing’ for investors, and for the specialist investment managers serving them debt is big business. Numerous managers are in the market seeking to raise a near-record amount of capital for lending strategies, according to Preqin, and some are seeking to raise debt mega-funds.

Of the private real estate debt capital raised in 2016, 70% is to be deployed in North America, according to Preqin (see opposite). There are 47 North America-focused private real estate debt funds in market profiled on Preqin’s Real Estate Online, seeking an aggregate $18bn (€15bn) of capital, or 60% of private debt capital being raised. In 2016, 29 North America-focused real estate debt funds closes, raising $16bn – the second-highest amount raised since 2010. All told, 195 North America-focused private real estate debt funds that have closed since 2010 have secured $78bn (€bn) in investor capital, Preqin reports.

robert morse

With interest rates low, “there’s been an enormous amount of capital oriented towards finding yield”, says Robert Morse, chairman of Bridge Investment Group. The demand for yield has compressed the return in certain sectors of the property market that are attractive to institutional investors, such as core office assets in US gateway cities. “There’s an enormous amount of competition for that paper, from private funds, from institutions, from direct lenders and others,” Morse says. “That capital has its own effects, of making the market very competitive.”

Bridge turns its sights elsewhere. “That’s specifically not where we compete,” says Morse. Bridge has about $2bn of capital in its second fixed-income fund and associated parallel vehicles, and has deployed it primarily in two major buckets. The firm is one of the largest acquirers of subordinated tranches of Federal Home Loan Mortgage Corporation K-series bonds – a securitisation by Freddie Mac of multi-family mortgage loans. “We believe they offer attractive returns, with a high degree of risk mitigation,” says Morse. Bridge also lends directly to asset owners through private mortgages.

Bridge concentrates on certain sectors, including multifamily, senior housing and office. The firm also makes equity investments in those sectors, engendering what Morse calls an “owner’s mentality”. The goal is to “identify assets that we think have strong collateral value that typically would be located outside of the urban core in gateway cities”, says Morse. “There’s less competition, particularly from overseas, low-cost capital.”

Bringing an owner’s mentality to the equation is critical. Morse says: “We ask ourselves a fundamental question: would we be comfortable owning this asset at 100% of value? If the answer to that is yes, we’ll try to structure an appropriate loan with a significant equity cushion. If the answer is no, we’ll move on to the next opportunity.” The net result of the process is that Bridge has been returning between 11% and 12.5% to investors, with current income providing most of that performance.

Investors eyeing commercial sector

Given where the market cycle is, investors are casting a cautious eye over commercial property, says Ryan Krauch, a principal at Mesa West Capital, a privately owned debt fund manager and portfolio lender. The result is that debt is now seen as preferable to equity as a way to participate in property markets. “Our investors understand that they can often achieve better going-in yield and average cash-on-cash returns by lending on high-quality assets than they can by buying them, while at the same time being in the most senior position of the capital stack,” says Krauch.

Over the past few years, investors and managers have developed a more nuanced approach to property debt. Early investors could choose mainly from opportunistic funds seeking to generate high yields by acquiring the debt of distressed property assets at deep discounts. Today managers have branched out across the risk spectrum of lending, offering core, core-plus, value-added and opportunistic strategies, Krauch says. Those broad categories are further refined by their focus on floating rates loans, and the duration of the portfolio. “Property is no longer just a yield play,” Krauch says. “The source of diversification is important, and investors want strategies that utilise property as a source of current income and downside protection. That allows private debt funds to diversify into some of the safer lending strategies and long duration lending strategies.”

For Mesa West that means focusing on providing non-recourse first mortgage loans for core, core-plus, value-added and transitional properties throughout the US. Mesa West’s lending portfolio includes all major property types, with loan sizes from $20m to $300m. Since inception in 2004, the firm has sourced and closed more than 250 transactions totalling over $11.5bn in principal value. “It’s a lower risk, lower return profile,” Krauch says.

Some larger investors have the option of participating across the capital stack. “In managing debt capital for our clients, we’re executing across the board in terms of fixed and floating rate, and stabilised core assets, as well as doing more value-add financing,” says Jack Gay, global head of debt investing at TH Real Estate. In the first half of 2017, TH Real Estate closed and committed on 43 transactions totalling $3.8bn, and manages about $22bn in debt assets. Scale confers flexibility. “In some situations we are capitalising or funding the entire debt stack for a project, and then looking at potentially selling off A-notes, or creating higher-yielding subordinate debt other parties might wish to invest in,” he adds. “In some cases, we’re able to approach equity-level returns with a comfortable cushion against downside movement.”

Local market knowledge is especially important in value-add situations. Gay says: “One of the strengths of this platform has been picking the right sponsors in the right markets with the right assets, and the proper structure and pricing for the loans.” Banks have traditionally been very active in the value-add segment, and the recent pullback of bank lending on such projects presents an opportunity. “We believe the current market represents better risk-adjusted returns in that space than we often see,” he says.

Interest rates on loans, which translate into returns for investors, are deal-specific, reflecting the risk profile of each transaction. Bridge loans typically carry floating rates based on LIBOR, priced in line with sector risk and the business plan of a particular asset. Fixed-rate permanent loans tend to be priced based on Treasury rates, which remain low from a historical perspective.

For any given asset, TH Real Estate might be involved in the financing for each stage of a project. “Mortgages in the US offer good relative value versus other fixed income products,” says Gay, “and we are targeting an increase in loan origination across the risk spectrum.”