Investors have discovered private debt. Precise numbers are hard to come by, but it is generally accepted that the private debt market cap stood at approximately $300 billion in 2008 and is now approaching $1.25 trillion at the end of 2022.
We can point to three prime reasons for this exponential growth: returns, diversification and being in the right place at the right time.
UPSIDE AND DOWNSIDE
The entire reason investors invest is for returns, and private debt in the past 10 years has proven a stable source of yields that are higher than fixed-income returns, but with less risk than private equity investments. The Cliffwater Direct Lending Index (CDLI), which contains more than 10,000 directly originated middle-market loans totaling $247 billion as of June 30, 2022, provides a good representation of private debt returns. In the 12 months ending June 30, 2022, middle-market loans had an average total return of 7.50 percent, while trailing five-year loans returned 8.32 percent and trailing 10-year loans reached 9.02 percent.
At the same time, S&P CreditPro found that between 1995 and 2020, middle-market private loans had a cumulative default rate of only 4.2 percent, while high-yield bond loans experienced a 12.3 percent default rate. On average, defaulted middle-market loans recovered 73.8 percent of their value, while high-yield loans only made back 40.1 percent of their value.
Debt fund returns weren’t always this stable. Before the global financial crisis, the funds tended to be highly levered and ended up paying for that during the crash. It took investors several years to begin to be comfortable with debt funds again.
“After the GFC, there was a bit of trepidation to start reinvesting into a product that had been one of the riskiest investments during the financial crisis. Many institutions had invested in highly structured, highly levered debt products, seeking opportunistic return profiles,” says K.C. Kriegel, managing director at PCCP. “After the GFC, there was a recalibration. We saw more lower-risk senior-lending strategies begin to fill some of the gaps opened by recovering banks, CMBS and insurance companies. Institutional investors began using debt funds as a substitute or a complement to core and/or fixed-income exposure. And I would say real estate debt has become much more accepted into traditional asset allocation models in the past 10 years.”
EXPANDING THE DEBT INVESTOR UNIVERSE
Debt funds started out as a means to access distressed properties, which was lucrative but appropriate for only a small universe of investors. Following the global financial crisis, however, when the expected distress did not materialize and fund managers needed to place record amounts of capital raised, debt funds expanded their reach. In the past 10 years, the asset class has matured and diversified, so investors now can find just about any strategy and risk/return profile they need.
“Private debt should be viewed as another tool for investment in real estate,” says David Maki, senior managing director, co-head real estate debt, at Heitman. “It can be fashioned for core, value-add or opportunistic strategies, and in the current market, we see the risk/return trade really favoring debt. Today’s market conditions are also giving investors the option to create debt investments across the risk/return spectrum using senior debt, subordinate investments and distressed loan sales.”
This diversification can easily be seen in the types of debt funds reaching final closings, as well as those currently marketing. According to Institutional Real Estate, Inc.’s IREI.Q database, of the funds closing year-to-date, as of Nov. 15, 2022, one has a core strategy, one has a core-plus strategy, two are focused on value-added investments, one is opportunistic, and one has a combined value-added/opportunistic mandate. Eight have an unknown strategy.
This diversification is not a one-year phenomenon. Since 2018, 105 debt funds have reached a final closing; 10 of those funds have a core or core-plus strategy, 14 focus on value-added opportunities, 11 provide opportunistic loans, and an additional 10 have a combined value-added/opportunistic strategy. Three are diversified within the fund, and 57 funds have an unknown strategy. You can’t get much more diverse than that.
Those funds currently in the market are even more widely diverse, as open-end funds tend to focus on core and core-plus strategies, balancing the closed-end funds that present higher-risk profiles. While value-added and opportunistic strategies are still the single most popular strategies, nearly half of funds are on the less risky end of the spectrum.
“Debt funds are not just for high-risk, distressed opportunities,” says Ben Silver, head of U.S. real estate debt at Barings. “We are lending across the board from core to opportunistic, seeking the best relative value throughout the capital stack. A property can be a class A well-sponsored asset but need just a little bit more leverage than the banks are willing to provide, or have a more complex business plan. Debt funds now provide financing for all kinds of assets and strategies.”
Additional diversification includes vehicle structure and region focus. While closed-end funds still make up the majority of vehicles currently marketing (57 percent), there is a significant pool of open-end and semi-open-end funds for investors who prefer those structures.
Regional diversification follows a similar pattern, with one region — North America — accounting for more than half (58 percent) of the capital raised by funds closing since Jan. 1, 2018, but a sizable amount of capital has been raised for other regions as well.
This diversification has opened up the available universe of investors who are interested in debt funds.
“We’ve talked to some real estate investors who have been using debt funds to diversify their real estate holdings as a complement to ODCE funds,” says Nasir Alamgir, head of real estate debt portfolio management at Barings. “It’s also about the relative value to other private asset classes. We’re seeing a demand for being in that safer part of the capital stack while being appropriately compensated for the risk that they’re taking today.”
RIGHT PLACE, RIGHT TIME
Analysis of the Cliffwater Direct Lending Index shows total private debt higher yields are associated with economic distress, and lower yields are associated with economic growth. Consensus among economists is that we are heading into one of those economic distress times or, at a minimum, an economically slow time.
“The consistency with which lenders have adjusted underwriting parameters downward and simultaneously brought pricing up is reminiscent of some past cycles, including the GFC,” says Maki. “For now, I don’t see credit markets anywhere near the imbalance we experienced in 2009, but there are certainly some similarities.”
With its history of excess returns and limited downside risk, as well as multiple strategy choices, private debt funds are poised to be an investment of choice for investors looking for ways to navigate economic uncertainty.
“Given the strength of the real estate market during the past few years and the financing discipline displayed by both lenders and borrowers since the GFC, it’s really hard for us to envision a GFC-like event happening now,” says Alamgir. “But even if we only end up in a mild recessionary-type environment, it certainly feels better to be in the debt part of the capital stack.”
TIME OF OPPORTUNITY
The real estate market has never been one to let a good crisis get in the way of opportunity. And this time will be no different.
“In my 30 years of credit experience, both on the corporate and real estate side, I’ve found that the loans you make at times like this usually end up with better performance because of reset values, lower LTVs and higher returns,” adds Silver. “It’s a good time to be more selective. You get better structures, and you get paid well. These more cautious recessionary years typically turn out to be a good vintage.”
Many of the most active players in the market agree.
“There will be tremendous opportunities at both ends of the credit risk spectrum,” predicts Shawn Townsend, managing principal and head of real estate credit at Blue Vista. “Unleveraged whole-loan financing outside of the securitization space will be increasingly attractive to borrowers who will value flexibility versus the rigidity of capital markets structures as they navigate an uncertain future. In regard to mezzanine/preferred equity lending, the scheduled loan maturities will most likely require borrowers investing additional equity to satisfy refinancing shortfalls driven by the higher rate environment and the lack of material amortization in their current debt. This will open demand for subordinate debt options in the marketplace.”
The dislocation in the real estate markets affects not only equity investors, but lenders as well.
“The best opportunities will be the purchase of performing and nonperforming debt,” predicts Josh Zegen, managing principal and co-founder of Madison Realty Capital. “For example, lending to other lenders who need leverage on their portfolios to help deal with repo or repayment issues from lines of credit. Also, borrowers that need to complete a project that may have timing delays or cost overruns.”
Real estate debt is poised to play an increasingly important role in investors’ allocations as this cycle evolves and the supply of quality lending opportunities increases. “We are in a part of the cycle when it’s good to be a lender, and there are significant tailwinds that favor real estate credit, both in terms of quality and yield,” says Ronnie Gul, principal at Mesa West Capital.
The overall supply of debt capital by traditional lending sources continues to be constrained, while the demand for balance sheet debt capital grows.
“We believe this is creating an imbalance that favors real estate credit managers that invest on behalf of institutional investors,” adds Raphael Fishbach, principal at Mesa West Capital. “As owners navigate this coming cycle, they will need time and capital to stabilize their properties, resulting in favorable market dynamics for lenders.”
During the next 12 to 18 months, some of the best opportunities may come from bridge financing, particularly on well-located multifamily and industrial assets with strong sponsorship, as well as opportunities to provide mezzanine debt and preferred equity to fill the gap in what are sure to be broken capital stacks resulting from this period of dislocation.
“We also expect opportunities to invest in distressed debt, whether buying loans on assets that have issues or from other lenders that need liquidity,” continues Gul.
CHALLENGES
Although the tailwinds look favorable for debt funds over the next year or two, investing still carries risks.
“Given most real estate debt funds leverage their loans, the senior financing market has become more costly and less available,” explains Rich Ratke, managing principal and investment committee member, head of debt platform, Walton Street. “In addition, debt funds that have legacy loans secured by office and retail will be challenged from an asset management and valuation perspective, as well as at risk of margin calls.”
Ratke also notes the next year will likely see an increased focus and concern regarding borrowers’ ability to meet increasing debt-service levels in a rising interest rate environment, as well as much more focus on and importance of asset management now compared with other years.
In addition to dealing with legacy issues, debt funds may have challenges providing new loans.
“Availability of leverage is something all lenders are dealing with,” says Zegen. “In addition, it is more challenging to underwrite deals with so much uncertainty and a very slow investment sales market. The bid-ask spread when you want to sell something is wide. This is a time when you need a firm that has the experience to handle volatility.”
Maki notes that if there is such a thing as a “normal crisis,” private capital has often been one of the relief valves to borrowers when traditional lending channels dry up. For the moment, a lack of financing — and senior debt more generally — is narrowing what private lenders can offer to the market. “Our challenges as a private real estate lender mirror many of the same issues confronting traditional property investors — the lack of consistently structured and priced debt to capitalize our investment portfolios,” he continues.
WHAT THE PEOPLE WANT
An old entertainment industry adage proclaims, “Give the people what they want, and they will come.” In recent years, the debt fund industry has taken that maxim to heart, and people are, indeed, coming.
“I view debt as an all-weather product,” says Kriegel. “For fund managers, it’s typically about how you risk-adjust your sector exposure, your market exposure, your borrower exposure, your advanced rates and your interest rates.”
As valuations come down in private markets and managers become more conservative with underwriting standards — as happens in almost all market corrections — private credit is positioned to be a solid source of income and excess return for investors.
Sheila Hopkins is a freelance writer based in Auburn, Ala.