IMN Winter Forum Takeaways: Debt Is the New Equity

By Jay Maddox, Principal, Avison Young

Investors remain cautiously optimistic, despite appearing to be in later stages of the U.S. real estate cycle, the prospect of higher interest rates, and the uncertainty regarding the economic policies of the new administration, according to attendees at this year’s IMN Winter Forum on Real Estate Opportunity & Private Fund Investing Conference in Laguna Beach, Calif. Hundreds of senior private equity executives attended the event, providing a great opportunity to take the temperature of the investment market. The general consensus is threefold: 1) Capital will keep flowing into commercial real estate; 2) Investors still view U.S. assets as the most attractive option among the limited menu of high-yield investments; and 3) The biggest challenge is deploying available capital in attractive opportunities.

Abundance of Capital and Decreased Risk Appetite

Private equity and opportunity funds are sitting on a historically huge mountain of investable capital.  According to industry sources, real estate funds have raised about $237 billion of capital for global investment in 2017, a near record amount eclipsed only by the 2015 total of $241 billion.

Investors continue to have difficulty finding value in U.S. real estate, particularly in core urban locations in gateway markets, as prices escalate. One sign of increasing caution is that many industry participants are shifting into lower-risk core assets. Opportunity funds are also increasingly attracted to lower-risk, value-add projects as opposed to riskier ground-up developments. The perception is that they may be late in the cycle, and the incremental returns for development projects may not be worth the added risk, particularly if return projections rely on aggressive rent growth assumptions. This tempering of investor interest is also impacted by higher interest rates, which increase projected costs dollar for dollar.

Debt is the New Equity

One of the key new developments is the significant shift by private equity funds into debt financing, primarily mezzanine loans and debt-like preferred equity, but also construction and bridge loans. The tremendous success that private equity funds have had in fund raising has fostered expansion from purchasing properties to providing debt financing, while at the same time new banking regulations under Dodd Frank and Basel III have precipitated a pullback by commercial banks, especially in construction financing. Money center banks are keeping their powder dry for their best existing customer relationships, and in most cases they require both recourse and a deposit relationship. As the banks have retreated, private equity funds have developed lending platforms to fill the void, offering greater flexibility, faster closings and higher leverage than banks.

By pursuing debt strategies, private equity funds are foregoing the higher potential returns on equity investments. Why? Because they believe they can achieve superior risk-adjusted returns. Mezzanine loans and preferred equity can achieve returns in the high-single digits to the mid-teens, depending on the underlying risk and degree of leverage.  Such investments involve lower risk than joint venture or straight equity investments, since they top out at 80 percent or 90 percent of project cost, as opposed to 95 percent to 100 percent for equity. From the funds’ perspective, the risk-return trade-off is acceptable, especially at this point in the cycle where values may be plateauing.

Private debt funds tend to pursue niche strategies and they often work closely with mortgage bankers to source good investment opportunities. There are dozens of new funding platforms, most specializing in certain types of loans, property types and geographic locations. For borrowers, it pays to work with a capital markets professional who can help identify the most suitable funding source, and assist and advise in structuring and closing the optimal transaction.