With fund managers stepping in to fill a void left by traditional lenders backing out of the market, private real estate debt investment activity picked up significantly over the past two years.
In 2011, fundraising for these vehicles peaked, with capital raised by solely debt-focused funds accounting for 16% of all capital raised by private funds, according to a special report by Preqin. Since then, institutional investor appetite for real estate debt has grown considerably from 8% in 2011 to 23% in 2013.
"A growing number of institutional investors are now targeting debt funds, with many believing they can provide them with strong risk adjusted returns," said Preqin's head of real estate assets products Andrew Moylan.
He added, "This may also be good news for managers looking to finance deals, with debt fund managers often prepared to lend at higher loan-to-value ratios, or to provide financing for secondary assets that might be avoided by traditional lenders."
Regionally, the U.S. has accounted for the vast majority of capital raised by debt funds historically.
However, increasing mortgage regulation and scrutiny of banks has left many investors to believe it’s an excellent time to invest in international real estate debt, according to Preqin.
Meanwhile, 10 solely debt-focused real estate funds raised an aggregate $2.5 billion by the time the funds closed.
While it’s a significant improvement, this area of the private real estate market is still relatively small, with some investors unfamiliar with the strategy and therefore less willing to invest in debt funds, analysts said.
Nonetheless, market analysts believe it makes sense that real estate debt will grow in popularity because it’s another way for institutional investors to ride the real estate recovery wave to bigger profits, explained RealtyTrac vice president Daren Blomquist.
"As home prices rise, that debt becomes less risky for two reasons: first, the property owners are less likely to default on a property where they have positive equity, or at least the near-term possibility of positive equity; and second, even if the property owners default, the debt holders are in a much more secure position to be able to recoup their investment via foreclosure," Blomquist stated.
He continued, "So certainly the investors should be looking primarily to purchase real estate debt on properties in markets where home price appreciation is strongest. Rising interest rates could make buying the real estate debt trickier, so likely the big increase is in part due to investors trying to capitalize on a window of opportunity that may not be open for long."
The availability of real estate opportunities — resulting from a large volume of maturing debt and tighter restrictions on banks — has led to an increase in the number of institutional investors committing to this asset.
The risk returns offered by debt funds provide an attractive alternative to equity investments for investors that are looking for stable returns from their portfolios, Preqin noted.
When looking at which types of investors will or will not invest in debt funds, real estate fund managers are overwhelmingly the most willing to invest with 49% of investors willing to do so.
Meanwhile, the number of private real estate debt funds in the market is at an all-time high. Consequently, with some traditional lenders more actively lending, there is significantly more competition.
However, due to the recent involvement of private real estate fund managers in the market, many lack a long track record, Preqin pointed out.
"With a great deal of competition in the fundraising market, and many investors unwilling to invest with first-time managers, it is likely to be the fund managers that can demonstrate a strong track record in making debt investments that are more likely to be able to successfully raise capital for their funds," Moylan with Preqin concluded.