When it comes to real estate credit, one portfolio's pain is another's gain

Real estate debt is both a boon and a curse, with higher-for-longer interest rates offering the potential for respectable returns as well as significant issues for existing investments.

The good news is there is a sizable investment opportunity offering rescue financing for borrowers needing to refinance their debt. While banks are beginning to once again lend to private equity-backed companies, they want nothing to do with real estate debt, which is wreaking havoc on their balance sheets. This puts private real estate debt managers in a fortunate position to capture that business.

"It's a really good time to be a nonbank lender,” said Eric Adler, president and CEO of PGIM Private Alternatives, which has $310.9 billion in assets under management. “Banks are making a comeback in private equity in general but not in real estate.”

The bad news is that real estate managers are sitting on portfolios with real estate loans coming due that will need to be refinanced at higher rates than originally anticipated, which could cut a big hole into returns. And the same interest rates that could offer higher returns than private lenders have seen in years are also increasing the cost of capital and making real estate valuations uncertain. As a result, transactions have stalled.

Until real estate transactions restart, there’s not a lot of volume for real estate private lenders, Adler said.

The bulk of the new loans have been in a few sectors including well-performing multifamily and student housing, Adler said. These are sectors in which there is not a lot of opportunity because there has been a consistent flow of capital into those spaces, he said.

There is a lot less capital available for real estate development, one of the riskiest types of loans, but unlike in the past few years, lenders willing to take on the risk will get paid for it, Adler said.

Real estate transactions are not expected to restart in earnest for quite some time.

“We are in the midst of a broad repricing of the entire real estate asset class as a result of a confluence of events that have happened over the last couple of years,” said Christy Fields, managing principal, real estate at Meketa Investment Group, at the March 6 meeting of the Oregon Investment Council, which oversees the $97.7 billion Oregon Public Employees Retirement System, Tigard. Meketa is the pension fund's general investment consultant.

These events include “deeply dislocated capital markets for commercial real estate largely caused by a rapid rise in interest rates,” she said.

“We have negative leverage for the first time in many people’s careers,” Fields said. “If you can get leverage at all today, the cost of debt capital exceeds going-in yields (future income compared to the purchase price) and so there’s an immediate drag on your portfolio.”

What’s more, the real estate industry is suffering from slowing rent growth, with office “the poster child” of this event, she said.

Everything industry executives “knew about analyzing real estate in 2019 is in the garbage because of these factors,” Fields said.

This has resulted in a dearth of transactions because owners don’t want to take the discounts that buyers are requiring, she said. The lack of transactions results in little market data, making it difficult for appraisers to assess real estate values.

“Noncore real estate managers are trying to raise capital and hunt for debt opportunities", Fields said. “It’s not really a virtuous cycle. Frankly, it’s the opposite.”

However, there are signs of loosening up. There have been a handful of distressed sales by distressed owners of real estate, she said. Banks are just starting to sell some of the loans on their books, potentially freeing up capital to make new loans and prices at or near the bottom, she said.

“We probably need another quarter or two, hopefully not three, to see that inflection point,” Fields said. "The sentiment in the market right now is survive until 2025,” she said.

While Oregon officials are keeping a sharp eye on the pension fund’s existing real estate debt, they are considering increasing the fund’s exposure to the real estate credit sector, said Gloria Gil, senior investment officer for real estate at the same meeting. The pension fund has $13.2 billion in real estate.

Their plan is to take advantage of the dislocation in the market by investing in private real estate debt, Gil said. Oregon’s staff is researching the potential of providing bridge financing to save troubled projects. Oregon officials are considering investing in structured debt, selling the senior part of the debt to another lender and retaining the mezzanine, which could provide double-digit returns, she said.

“It’s very attractive right now and it’s short-term” with a two- to three-year window of opportunity, Gil said.

Real estate debt is still a small sector of the asset class. Debt funds account for 16% of private real estate fundraising and 14% of infrastructure fundraising over the past four years, according to Preqin. So far this year, as of March 14, three funds closed on $1.7 billion, compared to $24 billion raised by 59 funds in all of 2023. That compares to 210 real estate debt funds in the market in 2023, seeking a total of $61.3 billion, Preqin data shows.

The biggest challenge in the market now is that borrowers can’t decide what their investment strategies should be, said Bryan McDonnell, managing director, head of its U.S. debt business and chair of global debt for PGIM Real Estate.

Borrowers are seeking much shorter loan durations because the future is uncertain, McDonnell said. In the past, real estate debt could last up to 15 years. These days, a borrower that might have sought a 10-year loan is asking for five years, he said.

“And there is a lot more capital than is advertised,” he said.

Commercial mortgage-backed security loan lenders are being very aggressive, offering very borrower-friendly terms. The spread between what an investor could earn from real estate compared to a bond is coming in quite a bit, meaning that there isn't much difference between real estate yields and the risk-free rate of a U.S. Treasury bond, McDonnell said. Banks are picking their spots and starting this year, bank executives are figuring out how to get their real estate debt problem behind them, he said.

“I’m more optimistic” because PGIM executives are finding some interesting deals especially in transitional lending, which is an area banks have shunned, McDonnell said.

But PGIM makes these investments “in a way where we can properly underwrite the risk,” he added.

PGIM is not alone.

“Real estate equity investors engage in a never-ending search for the lowest cost capital,” said Brian Carr, co-founder and managing partner of HighBrook Investors, a real estate manager with about $5 billion in assets under management.

“As deposit-funded banking institutions and insurance companies have experienced overexposure and looming defaults in their own balance sheets, private real estate lenders have moved in to take up the slack of traditional lenders,” particularly regional and smaller U.S. banks, Carr said.

“Certainly, as of yet, this hasn't precipitated a widespread banking crisis,” he said. “That said, it has created a window for the private real estate lenders to provide higher-cost loans on their terms.”

That’s the potential investment opportunity that lies ahead. There is also the legacy real estate debt, loans issued three or more years ago when interest rates were low that had optimistic property performance assumptions that did not reflect the scenario investors are faced with today, said Chris Hentemann, managing partner and chief investment officer at real estate management firm, 400 Capital Management, which has $6.2 billion in assets under management.

“I think legacy is evolving as we speak…it’s a slow-moving train wreck,” Hentemann said.

400 Capital trades securities, including commercial mortgage-backed securities, in a hedge fund-like structure and originates debt for longer-hold investment strategies.

“Rating agencies (of CMBS) are behind in adjusting ratings to the reality of real estate performance, and I think ratings are lagging,” Hentemann said.

“The real risk is not reflected in the ratings,” giving investment-grade ratings to securities whose assets have below-investment-grade risks, he said.

Hentemann sees the legacy loans as a potential opportunity set. Executives at 400 Capital are interested in good properties with bad financing where the current note holder just can’t hold the property any longer, he said.

“We can buy the loans at deep discounts and restructure the loans,” Hentemann said. "There are tens of billions of loans that will struggle to refinance.”

Kingbird Investment Management also sees investment opportunity in the millions of mortgages that will need to be refinanced in a much higher interest rate environment than originally anticipated.

"We believe there will be a meaningful amount of preferred equity opportunities" for the next 18 months, said Lei Farrand, managing director of capital markets and investor relations at Kingbird.