Real estate investors turn to debt strategies at top of market cycle

Institutional real estate investors are looking to debt strategies as price appreciation in many of the world’s core property markets has slowed.

Last week, Goldman Sachs announced that it had raised $6.7bn (€5.36bn) for its latest real estate debt fund. Broad Street Real Estate Credit Partners III, which invests in senior and mezzanine debt, brought in $2.7bn more than its predecessor.

Despite a capital raising slowdown among traditional (equity) real estate funds, 2017 marked a record year for property debt funds, according to Preqin, as 47 vehicles secured an aggregate $28bn from investors.

“Pricing in today’s market is weighing on income returns” according to PGIM Real Estate’s latest global outlook report, which notes that “capital is starting to target markets that can offer more attractive yields and stronger growth potential”.

The surge of institutional interest in debt indicates that investors are attracted to the capital protection that comes with a creditor position in a project’s capital stack, market participants say. At the same time, as overall returns from property have cooled, investors’ search for yield is leading them into submarkets and growth-dependent strategies that inherently carry more risk than core or core-plus assets.

The appetite for debt is prompting some large funds to tap specialists that can access smaller loans that carry higher yields but are not efficient for typically large institutional investors.

New York-based Gryphon Real Estate Capital Partners committed $250m to middle-market loans last year and has enough capital from investors to fund as much as $1bn in loans this year.

“We develop a strategy that fits what the investor needs in terms of risk profile, cash flow and other factors,” said Angelo LoBosco, chief executive of Gryphon, which creates customised debt strategies with middle-market transitional opportunities.

Yields on lower-risk “light” transitional strategies start at Libor plus 350bps from cash-flowing assets, while ground-up construction loans generate higher returns, he said. “Since our roots are in real estate rather than finance, we structure loans that work for the underlying real estate and business plan.”

LoBosco said, at the current point in the market cycle, it is important for debt investors to be prepared to weather adversity. “While it is not our goal, our workout and operating experience allows us to take a property back and manage the value creation if we need to,” he said.

As the cycle extends into 2018, TH Real Estate suggests debt is an investment “superfood” that can enhance portfolio performance. In a recent research note, the fund manager argued that adding commercial real estate debt “to a real estate equity portfolio at this point in the real estate cycle, which is arguably mature, and holding it through a cyclical downturn, can enhance both risk-adjusted and higher absolute total returns”.

The mature US market presents a “sweet spot” for property debt investors, TH Real Estate said.

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