Institutional allocations to commercial real estate debt are rising, and at the same time investors are becoming increasingly sophisticated in their due diligence of these strategies, according to Douglas Weill, a managing partner and co-founder of Hodes Weill & Associates.
The New York advisory company last month published its annual investor survey, which found the weighted average target allocation to real estate is now 10.7 percent, with an average actual allocation of about 9.3 percent. Investors who responded to the survey manage $13.4 trillion of assets, including $1.2 trillion of investments in real estate.
“We found in our survey that about half of institutions include real estate debt in their allocations to the sector,” Weill said. “Others either don’t have appetite for real estate debt or include it in a different part of their portfolio. It is still an asset strategy that is gaining momentum but not every investor that has an allocation to real estate has an allocation to real estate debt.”
As institutional allocations to real estate have grown, Hodes Weill is seeing more focus on the underlying credit risk in some of the strategies being marketed to investors.
“Institutions are scrutinizing the terms of the debt used to finance the loan portfolio, if it is match-funded or if it is short- or long-term or has mark-to-market provisions,” Weill said. “The market is much more discerning today than it was even 24 months ago. Another good example is questions around how thick of a piece of the capital stack lenders are taking. There is more risk associated with a sliver interest of 68 percent to 70 percent of the capital stack versus a wider interest of say 65 to 75 percent. The key question relates to the first and last dollars at risk.”
According to data from affiliate publication PERE, real estate private equity managers raised $17 billion for pure debt strategies through the third quarter of 2021, nearing the full-year total of $19 billion for 2020. This interest in real estate debt comes as yield-starved investors are looking at higher-yielding strategies, including value-added lending or lending on transition assets.
“These loans tend to be LIBOR-based, with terms of 18 to 24 months with extension options,” Weill said. “The collateral is generally assets that are going through some kind of improvement or redevelopment, which enables the lender to command a higher spread as compared to lending against a stabilized asset. Value-add or transitional asset lending generally nets an 8 percent to 9 percent return to investors, with a substantial portion of the return paid current. That is pretty attractive to institutions today which are looking for yield and the reason we are seeing such momentum in real estate credit strategies and fundraising.”
One of the challenges for managers and investors in credit funds is that the money comes back quickly, Weill noted.
“Managers can generate higher multiples by recycling capital, but given the short duration of the loans, invested capital can be returned within three to four years, as compared to five to seven years for a real estate private equity fund. This can create a challenge for institutions that want to keep their money invested. We’re seeing more discussion around longer-duration vehicles and the creation of open-ended credit funds that enable recycling while providing investors the option to redeem their capital, typically after a two- to three-year lock up.”