Real estate debt strategies in the US have been established for several years. But the market is becoming more competitive, writes Stephanie Schwartz-Driver

While the emergence of real estate debt funds in Europe is attracting a lot of attention, the equivalent market in the US, which has been established for some time, is still showing strong performance and continues to raise capital amid favourable market conditions.

A recent survey by Prequin revealed that, as of August 2013, there were 23 US debt funds in market, aiming to raise $12.2bn (€8.9bn). Compare this to the 17 funds focused on Europe that are targeting $12.4bn.

The strength of European activity is a reversal of the historical focus on the US, which has traditionally accounted for the bulk of the capital raised by debt funds. For funds that closed between 2006 and 2013, North America accounted for 83%.

But that does not spell too much trouble for US debt funds. Preqin also points out that the vast majority of real estate debt investors (73%) are based in North America, with 15% in Europe, 8% in Asia, and 4% outside these regions.

Today, US debt fund managers are benefiting from the financing gap created by the continuing slowdown in the CMBS market and the conservative approach that banks are still taking to real estate lending – as well as investor interest in the yields their strategies can offer under current market conditions.

CMBS lending remains well down from its peak in 2007. For the first three quarters of 2013, there was $60.5bn in CMBS issued, compared with only $48.3bn for the whole of 2012. But compare this to the $229bn that was issued at the peak of the market in 2007. Similarly, while national and international banks are re-entering commercial real estate lending, they are taking slow and measured steps.

“We’re looking at $70-80bn in CMBS issuance this year, which is still a far cry from where we were in 2006-07,” says Bill Stasiulatis, managing director at Torchlight Investors. “Then combine that with the maturities that are expected over the next few years. That funding gap has to be met somehow. That gap can be met by private lenders like us.”

Torchlight had its first close for its latest real estate debt fund in late 2012. The Torchlight Debt Opportunity Fund IV is focusing on private debt opportunities and aims to achieve returns in the mid-teens.

Michael Nash, senior managing director of Blackstone and the CIO of Blackstone Real Estate Debt Strategies, says: “The good news is that the market is very transactionally rich right now, a big change from 2009-10. There is a lot of real estate trading hands, and that is really relevant when you lend money.”

But although there is substantial activity, there is also more competition. For a start, the banks are beginning, albeit, slowly, to get back into real estate lending.

According to a recent survey by Chandan Economics, 71% of national and regional banks with commercial real estate exposure increased their lending over the past year.

And debt fund managers are starting to feel the effects of increased bank lending. “We will quote a transaction, and a bank will often come in and underprice us,” says Rob Little, CIO, finance at Cornerstone Real Estate Advisers. “It has gotten more competitive since there are more sources of capital in the market.”

Banks’ cost of capital is hard to compete against, Nash acknowledges. He says Blackstone’s deals are equally weighted between marketed deals and those related to existing relationships across the firm.

And as the space grows more competitive, managers are looking farther afield for opportunities. Little has seen the market evolve since the financial crisis. “Right after the financial crisis, and throughout 2009-10, we could get outsize returns from very safe, core lending,” he says. “But there was only a very short window before liquidity started to come back into the market. From there, people thought it was safe to go back to the pool and were soon willing to provide leverage of up to 70-75% loan-to-value to obtain acceptable returns.”

Today, a common theme explored by Cornerstone’s Alternative Debt Group is that the underlying properties have experienced some sort of cash-flow disruption, such as the loss of a tenant or capital shortcomings, Little says. The firm also does mezzanine development deals in the multifamily sector.

Robert Karnes, managing director and head of the real estate debt team of Blackrock’s Alternative Strategies Group, says: “We’re willing to look a little more broadly in terms of geography and product. It’s a real estate-based business, so we are not averse to looking at a secondary city or a property that needs improvement. The keys, as ever, are long-term leases, institutional quality tenants, properties that are competing well in their markets – you don’t always find all that, of course.” BlackRock also buys CMBS B-pieces, which gives a good perspective on the entire market, says Karnes.

BlackRock is looking at newly originated performing mezzanine funds, some originated themselves and some with partners. “We like exposure against collateral. Values are still reasonable, cash flows are still real, and valuations are recovering,” says Karnes.

Stasiulatis admits that Torchlight’s approach “requires being very opportunistic,” to achieve mid-teens returns without repurchase agreement (or repo) or fund-level leverage. “Our focus has been on off-market opportunities where there is a real problem at the property or capital structure, where we can bring a solution to the table to help,” he says. “We also find better risk-adjusted returns in opportunities that do not lend themselves to auction. We are competing on something other than price, where we can be creative.

“Over the last year we have seen a huge correction in real estate prices, and from our perspective this has been driven by availability of leverage. From the macro perspective, this availability of leverage has been driven by the Federal Reserve – the biggest risk is what happens when rates do rise. We think this opportunity set is going to be around for several years. It may not be the same as in 2009-10, but it is still an opportunity.”

Karnes agrees: “The economy has not taken off yet, and interest rates are low and will be so for some time – this is an excellent time for debt. We are early in the debt cycle, but debt investors will need to adjust their risk approach as the market changes.”

Nash believes that the factors muting economic growth in the US will benefit debt investors. “Debt availability has not come back to the 2005-06-07 levels,” he says.

“It is harder to borrow and costs a little more. This mutes the capital uptake. In addition, there are enough volatility concerns that may further encourage slow and steady growth and prevent over-exuberance. The factors that stop that from happening should lengthen our business model.”

Busier marketplace
The fact that current market conditions are favourable to debt fund managers means that many new managers have been attracted to the sector. The Preqin report found that around 40% of the capital targeted by debt funds in markets in the middle of 2013 was accounted for by managers raising their first debt fund. At the same time, the report pointed out: “The number of private real estate debt funds in market is at an all-time high.”

“There are more folks active in the space, but there’s also more to look at,” says Nash.
“We are all going to do a little more business.”

BREDS II, Blackstone’s newest real estate debt fund, had its first close in April 2013, taking in $2bn, and it has already closed or committed to 14 deals, investing about one-third of the fund. “In the rear view mirror, there is good news for us – we had more interest in the fund than we brought in,” Nash says.

“We had only two closings, because we did not want to raise any more. We try to size our funds to suit the market.” He indicates that Blackstone’s historical investment base is around $1bn annually.

Little has seen some fund managers reacting to the competition by taking more risk. “We have seen people cut margins and put leverage on transactions to get to the return target,” he says. “Leverage should be additive, not what drives the deal.”

Like other managers, Cornerstone is broadening its geographic focus. “It is a little harder in the big gateway markets. In 2010, there were ample opportunities in New York, San Francisco, or Washington DC. Now we have had to broaden our sights a little to cities like Austin, Texas, or Raleigh, North Carolina.”

Karnes also warned that some of the new entrants to the market might not be taking a prudent approach to real estate debt investing. “People chase yield or a securitised exit and they forget the real estate. There is no better lesson than what happened in 2006.”

This level of interest – and of competition – may not be anything new. “There is not nearly as much competition as there was in 2005-06,” notes Karnes. “We are seeing a good flow of business. We have closed a couple of deals in our recent fund and are about to close four more; we are happy with what we have been able to book.”

While the deals are around, not all players are finding fundraising in a crowded market to be that easy. “This has been our most difficult fundraise,” says Stasiulatis. “A lot of LPs have had a lot of bad experiences with managers. Pre-credit crisis, we were competing against 50 people, and now there are hundreds.”

Investor caution has been playing out in an interesting way, notes Stasiulatis, explaining that for LPs there has been a race to be the last into the fund. “Our expectation was that we would be done with the fundraise in short order, but now many investors prefer to be in the last close,” he says. “They want to see that the strategy is working and that it is viable, and they do not want to allocate to a fund that cannot raise capital.”

But despite investor caution and increased competition, Stasiulatis says, “we have had a decent amount of success so far, even if it has been an uphill battle.”

Competition from Europe?
The development of a European market in real estate debt funds does not trouble US managers. For a start, many of the fund managers becoming established in Europe are satellite offices of US businesses, notes Nash. “There is much less competition in Europe than there is in the US,” he says.

“We are not directly put in competition with European debt funds,” says Stasiulatis. “In conversations that we have had with LPs, people have an easier time getting their heads around the opportunities in the US – there is a natural country bias. People understand what our central bank has done to fix the problem. The path in Europe is more convoluted.”

“European debt funds will primarily attract European money,” says Karnes. “We have a European product, and we have seen some limited crossover from time to time.”

In fact, current market conditions are attracting European investors to the US, says Little. “European investors see a more predictable pattern of growth out of the downturn here than they do at home,” he says.

At the same time, Cornerstone is also expanding in Europe to take advantage of market conditions there, where it has identified, what Little calls, a “growing acceptance of different financing structures as well as a greater acceptance of US lenders.”

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