How Debt Funds View the Market

Aggregate capital raised by real estate debt funds reached $5.5 billion from 10 closes in Q4, second only to value-added funds, which totaled $6 billion on 25 funds, according to Preqin’s quarterly update on real estate.

Real estate debt funds raised less in 2023 than in 2022, but there was a strong showing toward the end of the year and into this year, Henry Lam, AVP, Research Insights, said in the report. Indeed, in January alone there have been numerous reports of funds raising $1 billion or more for CRE opportunities.

The need for this dry powder is clear:  CBRE is suggesting that US office owners will face a financing gap of $52.9 billion this year as just one example.

Unfortunately for borrowers, for the moment, much of this debt is playing a waiting game, Himanshu Tiwari, senior underwriter with private construction lender, Parkview Financial, tells GlobeSt.com.

He said that while secondary structured transactions like A/B participation, note on note, and note sales are on the rise with active participation from these debt funds, too much capital is chasing too few deals that continue to pencil out in the current market environment with reasonable underwriting assumptions.

“Despite stabilized interest rates and early indications of steadying construction and labor costs, uncertainty surrounding stabilized valuations prevails and remains the deciding factor for lenders,” according to Tiwari.

“CRE debt funds, despite sitting on ample dry powder, would continue to exercise prudence, prioritizing optimal returns while diligently managing downside risks and safeguarding capital in the year ahead,” he predicts.

Still, it is instrumental to see how debt funds, both active and in waiting, are viewing the current landscape and how that may shape their investment plans.

It is especially instrumental because they may wind up being the only game in town for some borrowers.

Drew Fung, Managing Director, Clarion Partners, tells GlobeSt.com that in the face of rising rates and uncertainty in the banking sector, non-bank lenders have real potential to fill the critical financing gap so many senior lenders, property owners, and investors are seeking while providing opportunities to both institutional and retail investors.

“While we have always been active in providing subordinate debt, the need for private lenders such as Clarion Partners to provide mezzanine and preferred equity capital to borrowers has expanded with the retrenchment” of bank lending, Fung said.

“While overall transaction volumes are down, many borrowers facing loan maturities have found that they need subordinate debt.”

To be sure this form of financing will cost borrowers: Private lenders are typically 2% to 4% more expensive than bank loans and often would be at higher LTVs, says Ran Eliasaf, Founder and Managing Partner of Northwind Group.

“Additional structure usually has several performance covenants, DSCR requirement in case of income-producing property and sales milestones in case of condo inventory, completion guarantee, carry a guarantee and standard bad boy carveouts,” Eliasaf said.

In some ways, this latest generation of funds are looking less like their older, more traditional counterparts, Andrew Janko, Managing Director, RCLCO Fund Advisors, tells GlobeSt.com.

“There has been an increased emphasis on senior and whole loan lending, in addition to the junior financing that was once the primary focus of debt funds,” he points out.

At the same time, they have retained their flexibility, which is one of their hallmarks, said Manish Shah, Senior Managing Director of Palladius Capital Management.

Shah notes that debt funds tend to have significantly lower leverage than banks and significantly longer duration capital, so the structure and terms of their loans can be more flexible and customized to the requirements of the sponsor and business plan.

“For example, there are debt funds like Palladius that have zero to low prepayment penalties and are willing to fund construction,” he said.

Bridge lending and rescue capital have been of particular interest to debt funds as well, says Lisa Knee, EisnerAmper Managing Partner and national leader of the Real Estate practice and the National Real Estate Private Equity Group, with the latter possibly in the form of preferred equity bearing high yield returns.

“Without property valuations showing a real reflection of the marketplace, bank lending will remain uncertain, and unwriting will be constrained allowing for debt funds to continue to provide liquidity,” she tells GlobeSt.com. “However, that will have a price, high rates for the debt funds, and lower returns for the equity investors.”

There are many structures a debt fund might consider, Daniel Diaz Leyva, Partner at Day Pitney, tells GlobeSt.com. “Debt funds may take a preferred equity position in asset ownership with a preferred return and prioritize repayment of their investment to other investors.

“The debt fund could also provide a bridge loan to pay off the maturing debt for a period, allowing for interest rates to presumably come down, at which point ownership would then refinance the asset with a traditional commercial loan and pay off the bridge loan.”

Alternatively, debt funds would buy the underlying debt and step into the shoes of the original lender assuming its rights and remedies under the existing loan documents, Leyva said.

“The debt fund would declare a default and move to foreclose on the asset and pursue any personal guarantees against the individual or corporate guarantors,” he said. “Typically, ownership would seek to deliver title to the asset to the debt fund in exchange for a cancellation of the debt and release of the personal guarantees.”

A debt fund’s stated strategy and targeted returns to its investors determines what its investments look like, according to Craig Oram, Managing Director, LaSalle Debt Investors.

“These range between core funds that solely originate first mortgages on stabilized properties to opportunistic funds that invest in a broad range of strategies including distressed assets and purchase of loan notes and subordinated tranches.

“If the loan is on a non-stabilized property where lease up or renovations are required, the loan will have an interest reserve to cover any projected shortfalls in cashflow. The loans are also structured with other protections for both the borrower and lender, including interest rate floors and interest rate caps.”

Additionally, he said, debt funds will originate preferred equity and mezzanine investments to fill an equity requirement for a borrower resulting from a lower leverage first mortgage.

For Chad Carpenter, CEO of Reven Capital, the newly launched fund that focuses on office lending, there is no typical structure.

“For viable office buildings, each lending opportunity will be scrutinized and customized based on the sponsor, building, and overall market situation,” he said. “Customized lending solutions that add value to business plans can create win-win situations.

He said Reven is looking to do business with experienced sponsors whose office investments have sound underwriting assumptions and are capable of producing cash flow to cover interest payments. We like larger office markets where the environment is business-friendly, safe, and where people want to live, work, and thrive.”