Lack of financing was a key trend throughout 2022. This is expected to continue into 2023, as difficult economic conditions are still causing sector headaches. In March 2022, the Federal Reserve began raising the federal funds rate from 0.25-0.5 percent. As of early May, it had reached 5-5.25 percent. This rise, along with broader volatility, has resulted in banks pulling back on lending in all asset classes, including real estate.
But with volatility comes opportunity, and current conditions are creating an environment in which alternative lenders can thrive. “When there is less liquidity in the market, opportunities increase for alternative lenders to make some attractive investments,” says Dan Riches, real estate debt co-head at asset manager M&G Investments. “As real estate values come down, the amount of debt an asset can support will reduce, and that is creating a funding gap to existing loan balances due for refinance. That is a particular area where opportunities exist for lenders such as us.”
As the alternative lending landscape continues to advance, here are five key trends to look out for.
1A transatlantic strategy
The past year or so has seen US credit fund managers seeking opportunities in Europe where lenders are pulling back due to macroeconomic difficulties. “[North American credit] funds are here [in Europe], and more are coming over because there is an opportunity,” says Paul Lloyd, co-founder and chief executive at credit specialist Mount Street. “These funds have a lot of capital to deploy, and they are deploying where many European lenders are pulling back due to market uncertainty.”
Clarence Dixon, global head of loan services at broker CBRE Loan Services, adds that firms want to be more diverse, which is also fueling the move across the Atlantic. “Many of these funds have been longstanding debt funds in the US. And the US market has been, is and will continue to be extremely competitive,” he says. “In the US, you have liquidity, but you don’t always have product. So it is about a diversity of location, a diversity of jurisdiction, but not necessarily a diversity of asset class because they will remain in the asset classes that they feel comfortable in.”
Higher loan pricing and European banks’ reluctance to lend are further emphasizing the opportunity in Europe. Nicole Lux, senior research fellow at Bayes Business School, cites Germany as a key example: “Right now, banks don’t want to lend anymore, especially German banks. Germany, in particular, is a market that was very difficult to get into. German bank pricing was so low that there was no point for debt funds. But now banks are charging a lot more – from 2.5 to 3 percent only in the senior space – while not really doing new business.”
It is not just Europe. The US also presents an opportunity for alternative lenders willing to lend where banks will not. However, the number of European lenders coming to the US is significantly lower than that of US lenders making the move to Europe.
Dixon says of this trend: “The US is a different animal. It’s much easier for a US lender to come to Europe than a European lender to go into the US. The US market is 99.9 percent broker-driven. And because there are longstanding interests and relationships between brokers and lenders, that allows them to execute fast and efficiently. European lenders are usually slower in their execution process.”
“When there is less liquidity in the market, opportunities increase for alternative lenders to make some attractive investments”
2Pullback from office
The office sector presents a gray area for investors and lenders – remote working habits adopted during the pandemic have prompted a lot of uncertainty as employees are reluctant to return to the office full time. This means office assets run the risk of becoming obsolete, thereby impacting lending opportunities.
“It is the sector where there is the greatest uncertainty as to whether alternative lenders will step in,” says Jack Gay, global head of commercial real estate debt at manager Nuveen Real Estate. “There is little to no liquidity for new office loans. Even if a loan is performing well, there is a good chance that when it matures there will be no option but to extend.”
Michelle Russell-Dowe, global head of securitized products and asset-based finance at manager Schroders Capital, adds: “Office will be the biggest headline in the real estate sector, even as delinquency is not yet very high. It is when the longer-term leases roll or when loans mature that the rise in delinquencies and defaults will be seen, and it’s unlikely that seasoned real estate professionals aren’t acutely aware of this. There is a fairly significant wall of maturities this year.”
She further argues that the future of the office sector relies on good quality, environmentally-friendly spaces as this will not only attract tenants but lenders as well.
Going forward, some industry specialists see office following a similar trajectory to the retail sector. “The chronic oversupply in the office market reminds me of what was seen in the retail space,” says Jeffrey Williams, senior portfolio manager at Schroders Capital. “Construction led to oversupply of retail malls, and the rise of digital shopping (e-commerce) magnified the problem. No doubt the office market in the US will go through a similar structural reconciliation.”
3Multifamily offers significant opportunity
Knowing which sectors to provide loans for can be a challenge for alternative lenders but multifamily is increasingly becoming an area of opportunity. Warren de Haan, founder and managing partner at debt specialist ACORE Capital, argues that multifamily is a great option for debt funds as in recent years good sponsors have bought quality buildings at historically low cap rates. “We are going to be providing a lot more high-yield money. ACORE will do billions of dollars of those deals at 13 to 15 percent rates,” he predicts.
John Lippmann, managing director and head of structured debt at New York Life Real Estate Investors, agrees: “It is a great opportunity for a debt fund to take advantage of senior lenders’ desire to de-lever when borrowers may be unable to recapitalize assets on their own. We are seeing that take the form of mezzanine and preferred equity in the market.”
Nuveen’s Gay also highlights industrial and alternatives such as student housing and self-storage as areas of opportunity with good fundamentals. “This is one of the most attractive markets that we have seen in maybe a decade to make new loans on commercial real estate,” he says. “We are playing in the sectors that have better tailwinds in this environment.”
“It’s much easier for a US lender to come to Europe than a European lender to go into the US”
4Offering flexible services
Challenging conditions often create an environment where innovation can flourish. Rob Brown, portfolio manager and head of real estate at investment manager ArrowMark Partners, sees flexibility of approach as a key strategy for managers navigating rising interest rates.
“This [rising interest rates] has meant we have had to be creative and provide capital solutions to address the circumstances we are living in right now,” he says. “A good example of that is being able to provide fixed-rate financing at a time when sponsors don’t want to take out floating-rate loans. Interest rate hedging cap costs are real, and we can provide a borrower with a three- or five-year fixed-rate loan with prepayment flexibility.”
He argues that a flexible strategy enables borrowers to get through tough times and prosper. “Structures like this allow borrowers to get through these volatile times to a place where they can sell, refinance, or recapitalize a loan on the backend when markets are calmer and borrowing costs have declined.”
5Focus on underwriting
Underwriting is a fundamental part of the loan process, and it is essential that managers ensure it is as seamless as possible.
“Everything we do, in terms of underwriting, is through the perspective of a real estate owner, aided by having both equity and debt businesses under the KA real estate umbrella,” says Andrew Smith, head of Kayne Anderson’s real estate debt platform.
He adds that partnerships with other banks and lenders are an important part of ensuring debt is in a protected position as it means the firm is not exposed when it comes to margin call risk or financing term risk. “We tend to issue loans on a floating rate basis to ensure we aren’t taking uncontrollable exposures, such as rate risk,” Smith says. “Every one of our loans has interest rate protection in place at the borrower level ensuring that borrowers don’t get overwhelmed by increased debt service requirements from rising rates.”