Debt in the spotlight

Real estate credit strategies to remain in focus amid elevated interest rates environment

For real estate investors, debt markets have become a significant focus in recent years. Since 2020, $110.7 billion has been raised for debt strategies across more than 330 closed-end funds. This accounts for around 16% of CRE fundraising, a sign of investment managers’ and investors’ expanding view of real estate opportunities.

The growth in debt vehicles highlights investors’ efforts to expand capital deployment across multiple strategies, deepening offerings across the capital stack. A multitude of investment managers and investors are looking to credit strategies as a growth driver for capital deployment, and to grow their assets under management (AUM).

It's timely as well. Credit strategies can perform particularly well during elevated interest rate environments when it comes to absolute yield. To look into the diversification benefits that debt strategies offer, we evaluated the spread between capitalization rates for commercial real estate and the all-in commercial lending rate in the US relative to the 10-year Treasury.

Since the onset of the Federal Reserve’s interest rate tightening cycle in the first half of 2022, credit strategies’ absolute yield has outperformed by 15 basis points. This compares to equity strategies’ yield outperforming by 220 basis points on average during much of the past cycle when interest rates were lower, speaking to the relative favourability of credit strategies.

Cycle since GFC characterized by more cautious lending environment

Lending activity during the past decade was notably more balanced and diversified compared to the period leading up to the GFC, where CMBS loan origination volume totalled 54% of originations. Debt funds, insurance companies — and, in the US, government agencies — have all accounted for a greater share of loan origination than CMBS in recent years.

And the average loan-to-value ratio of loans originated in the US since 2020 is 56%, a full 13 percentage points lower than the average ratio in 2007, generally indicating more conservative market behaviour. Loan-to-value ratios have ranged between 45% to 75% across larger European markets this cycle, and 40% to 60% across the larger markets in Asia Pacific.

New sources of debt are arising to complement funding options in markets and sectors where lenders are more cautious. Since the Global Financial Crisis (GFC), debt funds added significant lending capacity to the US market amid the slowdown of commercial mortgage-backed securities (CMBS) activity.

Considerable refinancing shortfall and opportunities

JLL projects $3.1 trillion of real estate assets globally have maturing debt by the end of 2025. Based on average loan-to-value rates across global markets, these loans total an estimated $2.1 trillion. Given the depth and maturity of its real estate lending market, some 77% of this is in the US. Globally, the living / multi-housing sector is expected to account for 25% of maturities, followed by offices at 23%.

Given the declines in real estate values since the market peak in early 2022, there will be many situations where new equity is required to keep loan-to-value ratios steady and continue to meet debt service covenants. The greatest risk relates to assets financed from 2019 to 2021 at peak valuations. The refinancing shortfall, meaning the amount of new equity required for these loan maturities, ranges from an estimated $270 to $570 billion, based on the range of value declines at the maturity date.

Loan maturities will catalyze transactions activity and, in some cases, distress. This will result in pressure in a multitude of situations, along with a significant opportunity for investors to deploy across the capital stack and risk spectrum through mezzanine financing, rescue capital or other structures, giving them exposure to new property sectors and geographies.

In terms of new capital, we expect private credit will continue to proliferate. Private credit can span multiple strategies, such as direct lending, mezzanine or preferred equity, and distressed debt. Significant opportunities exist for private credit as it relates to the wall of upcoming loan maturities in real estate as well as rescue-financing capital. In Asia Pacific, a wave of overseas private equity investors is ramping up their regional credit strategies.

The next several years are expected to offer an attractive environment for private real estate credit, where investors stand to benefit from opportunities where financing options from banks and other traditional lender types are more subdued.