Two decades ago, commercial real estate debt was a blip on the radar of an institutional investor. Today, the asset class is filling a unique but important role in institutional portfolios due to its ability to provide current income and protect against losses. That role is only expected to grow in popularity amid a sustained low interest rate environment. Institutions have increasingly sought fixed-income investment options offering strong risk-adjusted returns and higher yields than government or corporate securities.

“Real estate debt has become a really sizable component of many different styles of investor portfolios,” says Tim Johnson, Global Head of Blackstone Real Estate Strategies. “It offers compelling risk-adjusted returns, with a high component of the total return coming from current income. The return profile stands up well against things like value-add equity investing, but you have the downside protection of being a debt investor. You also have that cushion between the debt and the equity in volatile markets.”
It is this profile that has institutional investors turning to the asset class, notes Doug Weill, founder and co-managing partner of New York-based consultancy Hodes Weill & Associates.

“In a yield-starved world, to get to mid-single-digit-plus yields is very appealing to institutions,” Weill says. “The credit performance of debt strategies has been cycle-tested. In a volatile market environment these strategies seem to hold up well.”

The market is in such a volatile environment. As Real Estate Capital USA went to press, Russia’s invasion of Ukraine was escalating. Beyond the humanitarian concerns, financial markets already facing inflationary pressures stemming from supply issues brought about by the coronavirus pandemic have seen those pressures compounded by the conflict. This has meant more institutions are emphasizing the need for the current income and downside protection Johnson speaks of.

“Much of what we do is floating-rate [loans], and there is growing demand in a potentially rising rate environment for products like the ones we deliver,” says Michael Wiebolt, a senior managing director at Blackstone.

“I think, over the past 10 years, the market has accepted and come to appreciate the relative value the asset class delivers. And as we look around in today’s environment, real estate debt looks even better and [addresses] concerns investors have in an environment of potentially rising rates and other styles of volatility.”

Real estate debt as an asset class

Commercial real estate has been growing as an institutional investment class for 20 years, with a late 2021 report from Hodes Weill finding the average target allocation to the sector rose about 10 basis points to 10.7 percent from 2020 to 2021. The report also found institutions are under-allocated to the sector by about 140bps.

At the same time, a survey of 111 institutional investors by affiliate title PERE, published in February, found that 26 percent of respondents are planning to increase their allocations to commercial real estate debt in the next 12 months, with another 29 percent saying they would continue to invest at their current level.

“I think, over the past 10 years, the market has accepted and come to appreciate the relative value the asset class delivers”

Tim Johnson
Blackstone

Weill believes real estate debt will fill some of this gap as institutions seek to balance their allocations. “Four to five years ago, institutions started to really increase their focus on debt and that correlated with the perception of real estate being late in the cycle,” says Weill. “As institutions got nervous about investing in core real estate where yields were getting low, debt became an attractive alternative, providing the same types of returns. That was probably the catalyst that started to grow the industry and the allocations. As these strategies have performed well, they’ve continued to garner interest.”

Institutions want returns of about 8 percent in their real estate strategy. “So, if they can get that from credit, with good performance and low volatility, it makes sense,” Weill says.
While real estate debt has some appealing characteristics, the asset class has also gained traction because of a lack of alternatives within the broader fixed-income market. “The rise in allocations in real estate debt is really a reflection of this,” says Robin Potts, Canyon Partners’ co-head of real estate investments.

The global credit backdrop and the broad compression of yields within the fixed-income markets are other contributing factors. Within the broader fixed-income market globally, the opportunities to invest at attractive yields have been whittled down quite substantially, Potts says.

Right now, 93 percent of high-yield bonds are trading at less than the current rate of inflation. Historically, that figure would be less than 10 percent. Additionally, about 87 percent of global bonds are trading at less than 3 percent yield.

Real estate debt offers a consistent yield opportunity that is attractive from an asset backed perspective and has relatively low volatility. “And private credit within real estate has continued to gain traction from an allocation perspective because it provides an attractive yield and risk-adjusted return relative to broader fixed-income markets.”

The path to recognition

While alternative real estate lenders are now regularly raising billion-dollar funds, this was not always the case. According to data from PERE, capital raised for commercial real estate debt funds has risen since 2008, with a high point of $42.72 billion in 2017. But annual numbers have fluctuated substantially. After reaching $31.81 billion in 2019, capital raising dropped to about $22 billion in 2020.

Josh Zegen, co-founder of New York-based manager Madison Realty Capital, says commercial real estate debt as an asset class was not recognized in 2004. Much of the outreach Zegen and his partners did at the time was educational. But this changed as the broader US commercial real estate lending landscape was altered by the global financial crisis, the implementation of resultant, restrictive regulation and the exit of specialty finance companies from the lending market.

“Meanwhile, institutional investors broadened their investments into real estate, first on the equity side, and eventually in debt. I don’t think we ever believed it could get to where it is today,” Zegen reflects.

A major inflection point was the implementation of bank regulations Dodd-Frank and Basel III, which led banks to pull back on their commercial real estate lending, explains Richard Mack, chief executive and co-founder of another New York-based manager, Mack Real Estate Group.

“Institutional investors were pushed to seek more yield away from traditional fixed income asset classes, which hadn’t delivered sufficient return”

Emma Huepfl
CBRE Investment Management

“This was much more significant in the transitional [lending] space, which had been the province of commercial banks,” Mack says. “That became harder to execute and there became a need for alternative lenders.” The firm launched Mack Real Estate Credit Strategies with the intention of filling that transitional lending gap.

The shift toward alternative lenders came at an opportune time, as yields on traditional fixed-income investments dropped, says Emma Huepfl, managing director of EMEA credit strategies at Los Angeles-headquartered manager CBRE Investment Management.

“Institutional investors were pushed to seek more yield away from traditional fixed-income asset classes, which hadn’t delivered sufficient return,” Huepfl says. “As banks’ appetite for real estate credit reduced, it increased the need for other sources of capital to supplement overall market liquidity. A healthy yield premium has been consistently available to meet this market requirement.”

There is one other factor that investors found they liked about commercial real estate debt, according to Blackstone’s Johnson.

“Capital gets returned reasonably quickly to investors,” Johnson says, adding that this can nudge an investor toward a debt strategy. “When you invest in a high-yield debt fund, its loans are generally shorter duration. And as a result, you get that floating-rate product, you get the downside protection [and] you also get a chance to return a lot of your money over a three- or four-year period, for example.”

A key part of alternative lenders’ ability to grow their investor base – and their debt offerings – has been tied to borrowers that began to look past banks when seeking loans. “Many years ago, the bigger institutional investors, developers and owners wouldn’t have thought of an alternative lender as a source because it was like a dirty word,” says Madison’s Zegen. “‘Why are you borrowing from an alternative lender if you can go to a bank?’ they would say. But today, an institutional borrower will look at all of their options for debt.”

Madison Realty Capital now finds a much more nuanced approach to investing in debt. “We’re talking to investors who have managers with transitional lending, special situation investing, higher value-add lending or distressed lending. Now there are investors with different layers of debt, whereas in the past, investors had perhaps one debt manager,” Zegen says.

Inflationary impact

The question of the impact of rising inflation is expected to lead more pensions and other institutions toward commercial real estate debt strategies, in part because of the need to increase payouts to their constituents, market participants tell Real Estate Capital USA.
US pension funds are poised to offer their constituents higher payouts based on rising inflation, according to published reports. According to data from the National Association of State Retirement Administrators, approximately 50 percent of state pension funds tie benefits to the consumer price index. With rising inflation, this means there needs to be a commensurate increase in benefits.

There is a well-documented inflationary aspect to debt investing. “Higher interest rates feed through to the loans, and although there is less inflation upside in terms of asset appreciation in credit, financing real estate – which can capture higher rents through inflation – can be a good way to hedge risk,” says CBRE’s Huepfl.

The steady march of debt

Alternative lenders moved into the transitional lending space after regulatory changes that included Basel III and Dodd-Frank, raising capital to originate bridge loans and other short-term lending products. The capital allocated to these strategies hit a high in 2017, with market participants expecting to see more growth over the next 10 years.

2010

Regulation raft

Basel III and Dodd-Frank regulatory changes go into effect, putting stricter parameters around commercial real estate lending that helped push transitional loans from banks to alternative lenders.

2014

Bunds in the red

The 10-year German bund, a key measure of safe securities along with US Treasuries, moved into negative territory.

2017

High-water mark

Capital raised for commercial real estate debt funds hits $42.72 billion, the highest level ever seen on a yearly basis.

2020

First place fund

Blackstone closes Blackstone Real Estate Debt Strategies IV at $8 billion, blowing past its target of $5 billion to raise the largest-ever commercial real estate debt-focused fund.

Jeffrey Fine, a partner at Goldman Sachs Asset Management Real Estate, believes the high-growth segment of the commercial real estate debt universe is well positioned for an inflationary environment as long as proper underwriting is used.

“Will [inflation] create some stress in the system? I think it probably will, and from a lending point of view it will also present opportunity. Borrowers that have good real estate that is cashflowing should in theory be participating in a lot of the inflationary trends we are seeing,” Fine added.

Where debt sits

While increasing institutional engagement with real estate debt strategies is unequivocal, where these strategies reside in an institutional portfolio is not clear cut. “About half of institutions include real estate debt within their real estate allocation, and half do not. Real estate debt is often a strategy that straddles, or can sit, in another allocation in institutional portfolios,” Weill says.

Much of this is institution-specific, Fine notes. “We have so many conversations with different groups where they say, ‘I really like your strategy; it makes a ton of sense. But I don’t know whether this sits in credit or in real estate.’ It really lives in different places depending on the institution.”

But Zegen has seen more understanding of where debt should sit in recent years. “[In the past], debt often got lost. But today, the US is much farther along in terms of institutional investors’ understanding of the asset class, and the rest of the world is now catching up,” he says.

Heupfl, however, notes the nature of the commercial real estate debt is flexible. “It’s a versatile investment tool, so its role varies significantly,” she says. “Fixed income investors are usually focused on defensive characteristics, [while] allocations from real estate are focused on relative value to equity and may prioritize higher returns, faster deployment or use it do de-risk in sectors where value is full or uncertain.”

But at the end of the day, sources of institutional capital all want the same thing from the asset class: strong performance and stability, says Thomas Buttacavoli, chief investment officer at New York-based mortgage real estate investment trust Ready Capital.

“There is more money chasing and investing in commercial real estate debt, [especially] pensions which are allocating even more money,” Buttacavoli says. “It’s not going to stop and that’s a good thing. Even throughout the pandemic, direct investors of pension capital are realizing that there is very good relative value to commercial real estate debt when compared to corporate debt and middle-market loans. You’re seeing a relative value play.”

The investors that understand this are increasingly resolving to be overweight in the strategy, he adds.

As part of this ongoing evolution, there has been continued education around debt as an investment. For CBRE Investment Management, educating goes beyond selling the opportunities in the market. “It’s important that investors are crystal clear about the risks and levers needed to achieve them,” Huepfl says. “We also need to understand what the investor requires real estate credit to do for them and we weight these objectives in our credit convictions framework tool, a new proprietary tool that we have developed to help investors identify best risk-adjusted opportunities at any given point in time.”

“Now there are investors with different layers of debt, whereas in the past, investors had perhaps one debt manager”

Josh Zegen
Madison Realty Capital

CBRE GI expanded into European debt in November 2019 with the acquisition of manager Laxfield, where Huepfl previously served as a co-founder and co-principal of the business.

“It’s been a great two-way learning experience,” Huepfl says. “Our non-bank journey started with US life companies in 2010. They were already highly experienced debt investors and taught us a lot about liability matching and their more evolved non-bank market conventions. However, they were less covenant-focused than we were, and sometimes we had to persuade them that they mattered.”

Broadly, the level of education about the asset class is stronger than it was 10 years ago. This has been helped by investment experience spread through the industry. Part of the story is explaining to investors the role that structuring plays in today’s lending market.

Bryan Donohoe, a partner and co-head of real estate debt at Los Angeles-based manager Ares Real Estate Group, believes the lessons from the global financial crisis were well learned, and the structures subsequently adopted to address the over-leveraging then have had a positive impact across the real estate debt space.

“Opportunity funds have their leveraged capacity capped by their LPs and as an industry we’ve taken a more and more disciplined approach,” says Donohoe. “When you combine those two things, the result has been greater stability, even in the face of disruptions like covid.”

Looking ahead

As the lending universe has grown, so has demand from institutional investors for strategies that produce yield in a long-term, low-rate environment.

“The healthy categories [within real estate debt] will continue to attract capital and continue to inflate and appreciate,” says Goldman’s Fine. “We are going to see a lot more activity in the debt space in the next couple of years. I think some [managers] are better suited to navigating it than others. And hopefully, we’re on the right side of that delineation.”

Weill highlights some of the challenges. “It is definitely a growing market in terms of the number of managers and fundraisings and amount of capital allocations too. The challenge for managers is that the big players are getting bigger and claiming a higher percentage of the annual allocations.”

But broadly speaking, commercial real estate lenders are expecting to see institutional allocations to the sector grow.

“Our expectation is that this continues to grow as an asset class within investor portfolios,” says Johnson. “For all the reasons that we just described, I think the industry is continuing to mature and to grow. There’s been a good amount of growth globally.

“Since we started our business, we’ve become a big investor here in the US and have grown a significant presence in Europe, which was a market that didn’t have as many alternative lenders like us five years ago. I think that can continue in other places, like Australia, where we are growing our presence. I think there is room for continued growth in the sector overall.”

From peripheral to mainstream, real estate debt strategies have become a must-have and mainstay for institutional capital. With heavyweight managers like Blackstone, Ares and CBRE IM at the vanguard, this is a trend that has now crossed its Rubicon.