The rise in debt funds

A combination of changes in Basel regulatory capital rules and the Global Financial Crisis (GFC) constrained banks ability and cost to lend against some forms of commercial real estate. In the aftermath of the GFC, commercial real estate investment and development activity somewhat stalled, as borrowers were unable to secure credit to complete a transaction. 

Since then, investors have increasingly recognised the opportunity to establish debt funds to engage in direct lending, without the capital control parameters placed on traditional lending institutions. 

The initial demand from borrowers was for refinancing existing credit facilities on investments that had been underwritten prior to the GFC, and in many cases had loan covenants, which had been breached. 

Over the last few years there has been a growth of private debt funds in the market, and borrower demand has now shifted to acquisition loans. 

The result has been increased competition amongst lenders to secure terms for large loans, pushing lending margins close to the levels achieved by the once again active, but risk averse banks. Credit terms have loosened as a result of this sheer volume of debt chasing borrowers and lenders are now active outside the core markets and sectors. 

While lending terms have loosened, LTV’s have remained largely intact at around 60%. There has been an increase in the demand for loans in the 65-70% LTV range, but the cost associated with these loans is in line with the increased risk levels associated with them. 

There has also been a large increase in the demand for finance against operational real estate with a residential component. Specialist debt funds have positioned themselves to take advantage of this. 

Student housing, PRS and Hotel financing has attracted strong levels of investment over the last few years, requiring lenders to take on more complex underwriting procedures to better understand the operational business associated with the asset. 

While lender demand remains robust for most real estate sectors, retail has become increasingly difficult to lend against given the weakness and ambiguity of the future income stream. Lenders are less well equipped to enforce the security of the loan and assume ownership of retail assets that may potentially breach loan covenants and highly specialised skills or investment are needed to maintain values.