The Real Estate Credit Opportunity Is Here

Just as we discussed in February, commercial real estate transaction volumes have increased meaningfully over the last six months. The uptick in transactions is making the absence of banks, who have pulled back from commercial real estate lending, quite apparent in the United States.  The scarcity of capital and increase in volume is creating opportunities both in the near term and long term to earn equity-like returns on real estate debt. All told, we believe this will be an attractive vintage for real estate credit.

However, the opportunity in real estate credit is not just about conditions today, tomorrow, or next month. We see real estate credit as a compelling, evergreen opportunity to diversify both real secured equity holdings and the credit component of a portfolio with a high-yielding asset backed by real property and benefiting from a structural decrease in the availability of capital.

Below, we’ll discuss four ideas real estate credit investors need to know about today’s markets: (1) we believe property values have bottomed, (2) transaction volumes are increasing meaningfully, (3) U.S. banks are on the sidelines, and (4) current conditions look favorable for real estate credit.

1.  We believe valuations have bottomed.

Real estate capitalization rates have started to fall in both the United States and Europe (Exhibit 1). We are also seeing signs of a bottom in the prices of publicly traded REITs, which have either stabilized or are increasing since year-end 2022 (Exhibit 2). Office remains an outlier, but even there we are seeing signs of stabilization by way of higher leasing activity.

EXHIBIT 1
Real Estate Equity Cap Rates in the U.S. and Europe

EXHIBIT 2
Year-over-Year Change in Public REIT Prices

2. Commercial real estate transactions have increased meaningfully

The number of opportunities coming through our direct lending pipeline has increased from $14.5 billion a week in January 2024 to over $20 billion in August 2024. The change is also evident in publicly traded CMBS markets, where some forecasts predict issuance will reach $80 billion in 2024. That would be the highest level since 2021, which was an extremely active year.

There are several factors driving the increase in transactions. First, maturities on outstanding debt are coming due (Exhibit 3), and a large number of interest rate caps are expiring, the latter of which can act as a soft maturity date. Many of the loans coming due were for transactions that took place in the post-pandemic years of 2021 and 2022, when property values were higher and interest rates were lower. As owners look to refinance, they will be doing so in a higher-rate environment and at lower valuations, which drives pressure to sell. 

EXHIBIT 3
High Volumes of Near-Term Global CRE Loan Maturities

Second, the bid-ask gap has narrowed between buyers and sellers as marketed valuations have adjusted to reflect the higher interest rate environment. That’s coupled with the fact that the majority of buyers have spent the last 24 months effectively on the sidelines, leaving them with plenty of dry powder, including $258 billion in closed-end real estate funds, to take advantage of the current opportunity to buy at a discount. 

3.  Banks are parked on the sidelines in the United States.

Banks, which have historically accounted for approximately 40% of real estate lending in the United States, are largely still on the sidelines. We believe this pullback is a more secular shift. We expect they will remain active participants in the market, but if they reduce their activity to something more like 30% of commercial real estate lending, the gap would amount to roughly $300 billion (Exhibit 4). We feel that real estate credit funds or the CMBS market will likely have to become more active to maintain an orderly market, as other lenders such as government-sponsored agencies and insurance companies tend to maximize their allocations every year and do not have sufficient capacity to “step into the void.” 

EXHIBIT 4
Debt Outstanding by Lender Type

While U.S. banks are reluctant to lend on their own balance sheets, they are lending to other real estate lenders, including private debt funds and mortgage REITs, through back leverage facilities. For banks, this type of lending is more capital efficient, less time intensive, and may be seen as less risky. 

4. We think current conditions are favorable for real estate credit

We think this will be an attractive vintage for real estate credit. For one, we believe it will be lower risk than previous vintages. As valuations have reset, loan-to-value ratios for new originations have come down. That is partly because overall property values have declined, but also because loan proceeds, or the actual amount of money a borrower owes, have fallen about 30% since the first quarter of 2022, when property values were near a peak (Exhibit 5).¹ For lenders, this means a larger equity cushion and a smaller overall debt burden. We are often lending at some 50% of peak valuations.

EXHIBIT 5 
Estimated Debt-and-Equity Value on a Typical U.S. Light Transitional Multifamily Loan

Second, yields remain elevated relative to recent history. In mezzanine debt, yields on the same U.S. light transitional multifamily loan referenced in Exhibit 4 have risen from 10.1% in the first quarter of 2022 to approximately 13.7% in the second quarter of 2024. We’re also seeing attractive yields in the conduit CMBS market, where spreads on B-pieces have widened about 400 basis points since 2022 and the years prior.

Part of the reason transactions have accelerated in recent months is that a cooler outlook for inflation and interest rates has given potential buyers more confidence in their investment assumptions. We sometimes receive questions about whether lower interest rates mean a weaker outlook for real estate credit returns. We think not, as rates remain elevated compared to history, the lack of available capital should put a floor under borrowing costs, and more transactions will mean more opportunities to lend. This outlook, however, depends on the economy managing a relatively soft landing.

In terms of relative value, we are also seeing excess yield and spread versus BBB-rated corporate bonds (Exhibit 5). We think that this spread is likely to widen over time as transactions increase and banks stay on the sidelines, encouraging potential buyers to seek capital from debt funds with higher interest rates. 

EXHIBIT 6
Yields and Spreads of Commercial Mortgages vs. BBB Corporate Bonds

Conclusion

We are optimistic about the current environment for real estate credit investing, even at a time when interest rates are likely to come down. A growing number of commercial real estate transactions should increase the number of opportunities to lend, while the dearth of bank capital should keep yields attractive and spreads relative to corporate credit elevated. 

¹ Based on KKR estimates of a U.S. light transitional multifamily loan.