Managers have big expectations for debt sectors

The real estate industry is abuzz with the potential of debt as a winning sector, but Pensions & Investments' data shows mixed results from the past year.

Real estate mortgages and loans managed for U.S. institutional tax-exempt investors are up double digits, with mortgages up 11.5% to $93.6 billion and loans up 10.1% to $12 billion in the year ended June 30. Meanwhile, the other two credit sectors that P&I tracks, hybrid debt and mezzanine, were down, by 26.1% to $3.6 billion and 7.1% to $11.3 billion, respectively.

"Investor interest in debt and preferred equity strategies is largely driven by the market opportunity, with higher interest rates, higher credit spreads, and less competition from traditional lenders creating an environment where investors can earn equity-like returns further down the capital stack," said Nancy Lashine, founder and managing partner of Park Madison Partners, a private real asset placement firm.

Peter Rogers, director, investments-Americas and head of real assets research at Willis Towers Watson, said the tighter financial conditions offer the potential for equity-like returns from real estate debt strategies such as senior debt, mezzanine debt and preferred equity.

Over the five years ended June 30, loans have had the most growth, up a whopping 375.9%, followed by mezzanine with a 44.6% increase and mortgages up 33.9%. Hybrid debt has lost ground, falling 51.7% over the five-year period.

Real estate managers are not surprised that some debt sectors have lost assets under management during the year ended June 30.

"Real estate originations across all lender groups (banks, insurance, commercial mortgage-backed securities, private credit) are down about 50% from a year ago," said W. Todd Henderson, co-global head of real estate at DWS Group. "This closely matches the decline in real estate trading activity over the past year."

However, DWS Group executives believe that opportunities for private credit will expand in 2024 as transaction activity revives even as bank lending stagnates, Henderson said.

While DWS did not fill out the sector questions of the survey, Henderson said that overall the firm had $2 billion in U.S. real estate debt as of June 30, a 9.5% increase over the previous year.

"It's never been a better time to be a lender," said Shawn Lese, chief investment officer and head of funds management, Americas, for Nuveen's real estate business. Nuveen tops the list of managers of mortgages and mezzanine for U.S. institutional tax-exempt investors.

Nuveen had $34.9 billion in mortgages as of June 30, which was flat over the year, and $6.4 billion in mezzanine, which was down 4% from a year earlier. Nuveen is sixth on P&I's list of real estate loan managers for U.S. institutional tax-exempt investors with $679 million as of June 30, down 18.4% from last year.

Real estate lending deal flows are down because transactions, which are a good source of business, are down because sellers are waiting for interest rates to fall again, Lese said.

While many property owners want to sell, with the exception of office, they don't need to sell because their real estate is performing well, he said.

"Rental growth isn't what it was two years ago ... but there is no need to do a fire sale," Lese said.

"I'm cautiously optimistic that we are getting to the point that the bid-ask spread is narrowing," he said.

Tingting Zhang, founder and CEO of real estate debt firm TerraCotta Group, agreed that interest rates are the culprit from some real estate managers experiencing AUM declines.

"With 11 rate hikes in the past 15 months, the cap rate has expanded, and the underlying real estate value has declined," Zhang said.

TerraCotta's worldwide AUM was up about 3% to $526 million and it managed $106 million all in mortgages for U.S. institutional tax-exempt clients, up 22% from $87 million as of June 30.

Barings executives have focused their attention on raising real estate debt this year expecting favorable investment conditions for the sector, said John Ockerbloom, head of U.S. real estate, overseeing Barings' real estate debt and equity business.

Barings had about $2 billion in mortgages managed for U.S. institutional tax-exempt investors as of June 30, up 30% from the prior year.

While Barings in April closed out a real estate equity fund, its inaugural $680 million Barings Innovation and Growth Real Estate Fund, which invests in office buildings catering to life sciences and technology tenants, most of its capital formation energy was spent raising money for debt strategies, Ockerbloom said.

Institutional investor interest in real estate debt is up as the spread and interest paid on debt have climbed, he said.

The market conditions that exist today relative to the last 25 years in which Barings has been offering real estate debt strategies "are very, very favorable relative to what we have seen in that period, and we expect that to continue for the foreseeable future," Ockerbloom said.

In part, that is because banks and other lenders are not lending at present.

"Most groups including ourselves with existing loan books are not being paid back as quickly as they expected," he said.

"Very few borrowers are paying off existing mortgages," Ockerbloom said.

"If my mortgage matures, now I have the challenge of can I refinance?" he said.

Borrowers will have to pay more capital to refinance their mortgages at a meaningfully higher rate, Ockerbloom said.

"There is a large clog of existing debt that is not paying off in the same manner as one would have expected three or four years ago and dry powder for new lending has been reduced for some participants (lenders)," he said.

For its own existing portfolio of loans, if borrowers are willing to invest more money then, in those instances, Barings executives would be most likely to work with the borrower to extend debt maturities and restructure the loan.

"Where that isn't the case maybe there are other conversations to be had," Ockerbloom said.

Some managers are waiting for more of those conversations to start occurring so they can offer capital to borrowers that do not have the money to refinance and/or extend their loans. But it's been slow going, they say.

"We have invested some capital in the past year but it's definitely been slow," said Jeffrey M. Kaplan, founder and managing partner of real estate manager Meadow Partners. "The biggest characteristic of the year has been waiting for the gap financing opportunity to happen."

Meadow Partners, which provides rescue financing to smaller middle-market businesses, started out the year thinking there would be a lot of recapitalization opportunities as borrowers' debt maturities are coming due in a higher interest rate environment, he said. They thought that borrowers would need cash to make a big paydown to get a new loan, Kaplan said.

"Tension has been building … but borrowers have been pushing back and lenders are extending" mortgages, he said.

Lenders don't want to own the property either and so are de facto extending the loans rather than foreclosing on the properties, Kaplan said.

Meadow Partners had $2.4 billion in worldwide AUM and $2.2 billion managed for U.S. institutional tax-exempt investors as of June 30. Meadow did not participate in the survey last year.