Much Ado About Debt Funds

With billions in dry powder and a growing number of new entrants, these funds are reshaping the lending landscape and offering crucial support to an industry in flux.

The prolonged period of economic uncertainty and high interest rates has significantly diminished commercial real estate transaction activity, resulting in a massive stockpile of dry powder waiting in the wings. With traditional funding sources stymied, a wave of upcoming loan maturities, and investment activity on pause, it’s of little wonder that a growing portion of this built-up capital has turned its attention to debt strategies. (See Jim Costello’s January 19, 2023, “US Property Deals Slumped, Price Growth Withered in Q4” and Mortgage Bankers Association’s April 23, 2024 press release “Total Commercial Real Estate Borrowing and Lending Declined 47 Percent in 2023.”

The influx of capital into debt funds is significantly reshaping the private lending industry, particularly in the context of current market conditions. It seems like there’s a new fund coming onto the scene every other week, many of which are backed by the biggest names in institutional investment. Private credit funds have certainly proliferated in the U.S., rising from $436 billion in 2013 to more than $1.7 trillion in 2023, according to a Federal Reserve study of Preqin data. Direct lending, specifically, rose from $95.4 billion to nearly $794 billion, including $220 billion in dry powder, over the same period. (See Joe Palmisano’s “Real Estate Debt Funds: Pouncing on the Opportunities.”)

The universe isn’t as vast when it comes to commercial real estate debt specifically. Prequin reports a total of 59 funds raised $24 billion in 2023, and another three vehicles closed on $1.7 billion as of mid-March 2024. Since 2019, U.S. managers launched nearly 500 new real estate debt funds—all of which are vying for a piece of the $2.8 trillion pie of mortgage maturities being served over the next four years.

Private capital has proven to be an invaluable tool that’s helping to keep the wheels of the commercial real estate industry turning. The influx of new entrants to the field will certainly play a major role in the continued evolution of the capital markets. Yet to determine how big of a role—and how the story will likely play out—we must first look at how current fundamentals are shaping up amid the broader market reset.

Interest Rates’ New Normal

Skyrocketing interest rates brought commercial real estate activity to an effective standstill as property owners and tenants put off major decisions until rates fell back into a favorable range. Transaction volume fell by 50% and cap rates widened by 60 basis points year over year in the second quarter of 2023, per CBRE. Average property prices were down 22% from their March 2022 peak, with office assets falling as much as 40%. (See CBRE’s March 7, 2024 press release “Cap Rates Approach Peak Levels Despite Tighter Lending Standards and Potential Distress, CBRE Survey Finds.”)

The first three months of this year saw more of the same. The $31.6 billion in closed sales was not only a 28% drop from first quarter 2023 but also marked the lowest volume recorded since 2013, according to an April 17, 2024, report from Altus Group “US Commercial Real Estate Transaction Analysis—Q1 2024.” Refinancing activity was also low because lenders have been eager to work with troubled borrowers; a flurry of modifications and extensions has kept the level of distress low.

Although the approach has kept many lenders out of trouble and given borrowers some breathing room, it’s only delayed the inevitable. Roughly a third of the $930 billion in debt maturing this year was originally set to mature in 2023. (See Mortgage Bankers Association “2023 Commercial/Multifamily Annual Origination Summation.”)

After 11 hikes in two years, the Federal Reserve left interest rates unchanged again in May 2024, as Chairman Powell remains intent on bringing inflation down to its 2% target rate. This means it’s unlikely to see rates move down until the end of the year—at best. Many experts cited via major media outlets don’t expect to see significant movement until 2025. Until then, CRE players must adjust to the reality of higher borrowing costs. (See transcript of Chair Powell’s May 1, 2024 press conference.)

Today, one of the fundamental questions circulating in the finance arena is how much longer lenders can play the extend-and-pretend game. Resetting property values, reduced NOIs, and higher-for-longer interest rates are progressively testing the limits of most conventional lenders’ flexibility.

The other question is how much longer before rates come back down, and it looks like we’re nearing a consensus. The more market participants accept this new rate environment, the more movement we’ll see in transaction activity. Faced with the market’s realities and out of lifelines from lenders, a growing number of borrowers will find themselves out of options. Even the most patient sponsors will be driven (or forced) to make a move. Whether that’s a refinance, sale, or default depends on several variables.

Sidelined Banks Might Be Out for Good

Regional bank failures and subsequent retrenchment by traditional lenders severely depleted the amount of debt capital available in the market, and there’s little indication that banks will loosen their grip on their purse strings. Recent Federal Reserve surveys found that more than two-thirds of banks have tightened lending standards, and the Mortgage Bankers Association reported a nearly 50% drop in origination volume for CRE.

With increased regulation (such as the upcoming implementation of Basel III guidelines)—and as delinquencies and defaults of bank loans ultimately rise—the pressure on traditional capital sources isn’t likely to ease. A 2023 year-end study by Fitch Ratings reported that nearly 1,900 banks with assets less than $100 billion held commercial real estate loans aggregating over 300% of their equity, which the Federal Deposit Insurance Corp. says may indicate significant exposure to CRE risk. (See the BIS’s September 11, 2023 notice “Governors and Heads of Supervision Endorse Initiatives in Response to the Banking Turmoil and Reaffirm Priority to Implement Basel III.”)

Many banks are shoring up their reserves for expected loan losses, while some are even taking steps to ease their CRE burden by selling off notes, often at a significant discount to underwritten asset values. Some are also tapping alternative lenders to help restructure some loans, or for capital infusions themselves. While this is providing an opportunity for some alternative lenders to increase their CRE debt holdings, the trend is far from widespread; for now, the deals seem to be limited to quiet one-off trades or large portfolios from troubled banks that only the biggest players will attempt to tackle.

Given these developments, don’t expect banks to increase their appetites for CRE lending. And since that segment has historically provided about half of all U.S. commercial property loans, it leaves a massive funding gap that many other capital sources will be unable—or unwilling—to fill. (See Zoe Sagalow’s April 30, 2024 “US Banks Selling Commercial Real Estate Loans to Get Ahead of Stress, Diversify.”)

Private CRE Debt Minds the Gap

The chasm in debt availability left by the retrenchment of traditional lenders will become even more noticeable as transaction activity picks up. At $220 billion, Preqin’s estimate of private real estate debt funds’ dry powder is a mere drop in the $5 trillion bucket of outstanding loans. A broader slowdown in fundraising means that some of the recently launched vehicles might not reach their capital targets and deploy, further reducing capital availability. This probably won’t be as widespread since returns for CRE debt are expected to outpace other asset classes, given weaker property performance and income growth.

There’s plenty of room for growth, too. According to MSCI, debt funds, and other investor-driven lenders accounted for just one in 10 commercial property loans in 2023—and that’s only counting first mortgages and senior debt. The opportunities are even greater for providers of bridge loans, which comprise a large segment of nonbank lenders and can be applied to several use cases.

After such a long wait-and-see period, transaction activity is expected to pick up as buyers and sellers go through the price discovery process. Even if assets don’t trade, the volume of expected refinancing opportunities alone will be enough to keep lenders busy over the next few years.

For owners of quality, performing real estate who want to hold out until interest rates decline next year, private debt’s shorter terms offer an ideal delay tactic. The same holds for assets in transition; many of the loan requests that cross our desks involve borrowers seeking a little cash infusion and extra time to complete their business plans, which can range from lease-up efforts to stabilize an asset’s rent roll or finishing a construction or redevelopment project.

With demand for debt expected to outpace capital availability in the near to medium term, well-heeled, experienced private lenders will be well-positioned to benefit. The stalwarts of this business—that is, dedicated nonbank lenders with the expertise, creativity, and knowledge to cherry-pick the best opportunities—will stand out in their ability to make attractive deals pencil out.

Private Lender Much Ado About Debt Funds