Capital Investment Roundup: Debt is the New Darling; Investors Starting to Look to European Shores
The following was distributed as part of the Real Estate Private Equity Fund - First Quarter, 2014 newsletter.
The redistribution of capital among different investment strategies, regions, and property types is a direct reflection of larger economic trends. Here are some of the more notable investment trends of the first quarter:
Debt funds grew to be nearly as popular as opportunity funds, as investors anticipated the effects of Basel III: lower levels of bank lending, higher interest rates, and longer execution times to accommodate more extensive due diligence. While debt funds will still charge at a premium to banks, the spread will narrow, making private equity debt increasingly attractive to developers, particularly those seeking ADC loans. Many developers will attempt to combine the best of both worlds in financing their deals. “By limiting the bank loan to, say, 50% LTV and taking 30% LTV loan from a fund, the project becomes palatable to the bank and the interest rate for the entire project is less than it would be had it been financed solely from a debt fund. Such strategies will further solidify the place of debt funds in the commercial real estate ecology,” said David Kessler, National Director of CohnReznick’s Commercial Real Estate Practice.
Opportunity funds continued to lead in fundraising in the first quarter. But money alone does not a deal make: The challenge going forward will be to continue to find deals that meet expectations for both risk and return. With the primary markets picked over, deep-pocketed large funds are squaring off against more agile specialty funds in secondary and tertiary markets.
Investors cooled toward the value-added sector, where increased deal cost has made 15% the new 18%, and 12% the new 15%. Unfortunately, this sector also has a high concentration of new fund launches, as entrepreneurial fund managers leave larger funds to try and replicate past success on their own. New funds in this sector face a serious uphill battle, given the sizable supply-demand disconnect.
In the first quarter, the sites where office properties showed the greatest returns were Houston, Denver, Dallas, Phoenix, and San Francisco. Interestingly, these are not necessarily the same places where job growth is highest. Why? “All five are particularly strong examples of a phenomenon at work in cities across the country: Old office buildings, poorly suited to twenty-first century work environments, are being repurposed into residential or hospitality properties, further straining an office stock that has seen little new building since before the downturn,” Kessler noted. In addition to drawing U.S. investors, the office sector is also a favorite of foreign investors, particularly those from Canada, China, the Middle East, and South Korea.
Retail saw a noticeable spike in deal flow in the first quarter, fueled by strong consumer confidence, a robust specialty retail sector and portfolio rebalancing. At the same time, investors started to back away from the multifamily sector, wary of saturation in what has been commercial real estate’s hot market for some time.
Looking at capital through a regional lens, the first quarter saw a sizable shift in investor demand from North America to Europe, fueled by the quest for higher returns. Debt funds have been active in Europe for some time, and it is notable that of the top ten funds that closed in the first quarter, three were European debt funds, ranging in size from just under $1 billion to $1.2 billion.
Examining the difference between the funds in the market and where investors are putting their money is a quick way of determining where funds will face particularly stiff competition and where there is opportunity to serve unmet investor need. The Supply-Demand Spread Tables look at the difference between the amount targeted by each type of fund, as a percentage of the total funds targeted, and the amount raised by each type of fund, as a percentage of total funds raised.
For more information, please contact David Kessler, Partner and National Director of the Firm's Commercial Real Estate Industry Practice, at 301-657-7755.
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