PErspective in Real Estate

A feature examining the role of private equity in the real estate sector.

Federal regulators—the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC)—have increased their scrutiny of commercial real estate loans, urging lenders to strengthen terms amid fears of a real estate bubble. This is deterring small, local banks from issuing new loans, and many are selling off the loans they do own to PE firms, pension funds, foreign banks and other institutional lenders, according to The New York Times. Large banks are also retreating, as they can no longer count on selling portions of large loans to smaller banks.

The absence of other lenders is drawing PE firms, hedge funds and REITs into the debt investing space, with a particular focus on bridge and mezzanine loans. Last year, private equity real estate debt funds raised $15 billion, with just 5 percent of firms targeting bridge loans. Research firm Preqin predicts fundraising will be stronger this year, with 48 percent of firms targeting mezzanine loans and 23 percent considering bridge loans. Just 5 percent of firms were looking at bridge loans last year.

The last four years have seen a rush of new bridge lenders coming to market, including Calmwater Capital, Streamline Realty Funding, ACORE Capital, Amherst Capital and RealtyMogul, National Real Estate Investor reports. Existing private lenders—Blackstone and Starwood at the high end, as well as smaller lenders, including PrimeLending, Mesa West Capital and Garrison Investment Group—have increased issuance, providing non-recourse transitional or bridge loans.

Pension funds and institutional investors have been increasing allocations to real estate over the past several years, despite geopolitical uncertainty that has reduced confidence in the market. Average target allocation to real estate among global institutional investors will hit 10.3 percent in 2017 totaling more than $1.07 trillion, up from 9.9 percent in 2016, according to a study from real estate advisory firm Hodes Weill and Cornell University. However, as a defensive strategy ahead of a potential down cycle, these firms are increasingly focused on debt rather than equity, according to The Telegraph.

Despite the maturity of the market, capital will continue flowing into the sector in 2017 as institutional investors seek to achieve their return objectives in the continued low-yield environment, National Real Estate Investor reports. But class-B properties in secondary cities—which can offer higher yields, but are riskier—are becoming less popular. Instead, many core institutional investors are exercising more caution and flocking toward more reliable assets in major market areas with credit tenancy and sold leasing in place.

There is a potential for strong exits and fundraising in the current market. PE titan Blackstone sold $7.2 billion in real estate assets in the third quarter, and raised $68.5 billion in new funds during the first three quarters, lifting the firm’s assets under management to a record-high $361 billion, The Wall Street Journal reported.

As real estate becomes an increasingly mainstream alternative asset class, debt-related funds present a significant opportunity for PE firms and pension funds looking to achieve reliable returns and safeguard against a potential downturn in the real estate market.

Sources: Bloomberg, Mansion Global, National Real Estate Investor Online, New York Times, The Real Deal, The Telegraph, Wall Street Journal

Future PErspectives: What’s Next for Real Estate Investors?

Trump administration policy details are largely still unknown, but proposed tax cuts and infrastructure spending could be a boon for real estate development as well as the construction industry. However, if the tax rate on carried interest is increased, as President-elect Trump has previously advocated, it could dampen PE real estate deal flow, according to Bloomberg. On the other hand, a separate and contradictory proposal could reduce the tax burden for hedge fund, VC and PE fund managers dramatically, having the opposite effect. Meanwhile, protectionist policies could hurt international investment. Cross-border spending reached $100 billion in 2015—18 percent of total U.S. commercial real estate spending, Bloomberg reports. For the near future, uncertainty is the only certainty, and fund managers may seek to diversify their holdings, to the benefit of secondary markets like Melbourne, Amsterdam and Vancouver, according to Mansion Global.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com