Volatility in the regional banking sector could mean a significant shift in the composition of the commercial real estate lending market going forward, with more debt funds and alternative lenders taking center stage as traditional sources of capital step back.
Diana Brummer, a partner at New York law firm Goodwin, notes the change is already being seen as established debt-focused managers are raising fresh pools of capital and new managers are looking in the space. The sector could also see more separately managed accounts focused on real estate lending, she adds.
“We are seeing a big increase in fundraising by private investment funds that focus on lending, and this is definitely more than a modest uptick,” Brummer says. “The sources are planning to fill the void that has been left by some of the banking issues and they see an opportunity to put out capital when banks are not.”
The drumbeat grows louder
According to Real Estate Capital USA‘s annual ranking of North American debt managers, which was published on June 1, the 40 largest firms raised $164.8 billion for the five years ending in 2022 – an uptick from the $132.1 billion raised for the five years ending in 2021.
There are several reasons why this increase is being seen, according to a May report from Ares Capital Management. The New York-based manager cited reasons including higher base rates, increased equity subordination, wider credit spreads and the well-documented funding gap driven by changes in the banking industry.
The report, The Growing Investment Opportunity for Commercial Real Estate Debt, estimates that the long-term opportunity for alternative lenders could grow from about 40 percent of the market in the US to substantially more than that.
The report’s themes have been echoed in a handful of similar reports and white papers published over the past month, including Miami-based FS Investment saying that real estate investing will need to increase focus on income generation due to banking volatility, and that non-traditional lenders will increasingly take up the lending mantle as banks pull back.
The FS Investments report, A Dense Fog, underscores that the near-term outlook for commercial real estate is uncertain due to weakness in the office market, higher capital costs and uncertainty about whether will be additional fallout from current volatility in the banking sector.
Still, Andrew Korz, the report’s author and the firm’s director of research, believes a necessary correction is underway. “The market is coming to grips with a world in which capital is more expensive,” he says.
While allocations to all real estate private equity were depressed in the first quarter and lending activity is still slow – a May report from advisory CBRE cited a 53.5 percent year-over-year drop in lending volume – anecdotally, there has been a marginal uptick in financings.
Brummer, who has started to see these trickle across her desk, says believes this is significant.
“It points to people thinking US interest rate hikes are going to settle down or have already reached their peak,” says Brummer. “The biggest unknown was where will interest rates go, because substantially all of the real estate industry uses leverage on their properties, and they do not know what to pay for; what the interest rate will be; and how [this impacts] their financings.”
Having decreased visibility on anticipated trends in the leasing market is also having its effect. But the market is starting to move ahead.
“I do think people are starting to feel a bit more comfortable about where they think the maximum interest rates will be – no one has a crystal ball but that they’re starting to get more comfortable,” Brummer says.