Amidst uncertainties plaguing the banking sector, the spotlight has shifted towards real estate debt funds as a potentially significant player in gaining market share. There are emerging signs that certain funds are pivoting towards strategies centred on opportunistic and distressed investments. This shift could offer a crucial capital lifeline to office property owners facing challenges securing alternative refinancing options.

According to data from Preqin, we witnessed the closure of 78 real estate funds in the first quarter, collectively raising $20.6 billion. This represents a decrease of 42.6% in the number of funds and a 64.5% drop in capital raised compared to the previous quarter. Notably, 26% of the fundraising efforts for closed-end private real estate were primarily focused on real estate debt, constituting 17% of the closed-end personal real estate assets under management. Furthermore, a survey conducted by PERE revealed that 38% of real estate investors plan to target real estate debt in the upcoming 12 months, marking a substantial increase from 18% in the first quarter of 2022. Since 2018, real estate debt funds concentrating on North America have amassed over $111 billion, per Preqin’s findings.

“This indicates a strategic interest among some real estate debt funds in targeting vehicles within the distressed real estate sector, which are perceived to have a higher risk of default,” remarked Alex Murray, Vice President of Research Insights at Preqin. “These funds, aiming for higher returns, are acutely aware of the potential to acquire assets at a discount, especially if equity holders decide to exit.”

Palladius Capital Management, a diversified real estate investment firm based in Austin and managing approximately $600 million in assets, is among the entities aiming to offer financing solutions while seeking to expand its debt operations.

In a statement made in September 2022, the firm announced its intention to raise $300 million dedicated to real estate debt investments across the United States. To date, approximately $100 million has been submitted, with the firm optimistic about reaching its goal within the next 18 months, according to Marko Velazquez, Senior Managing Director at Palladius.

“Given the current climate, marked by negative publicity in the mainstream media—much of which is grounded in reality—this moment is exceptionally opportune for our business,” Velazquez observed. “Our role becomes critical when larger institutions and regional banks find themselves constrained in providing the necessary rescue capital, positioning us as a key player in this domain.”

The firm in discussion is actively seeking loans that typically offer a return of at least 9 per cent, as per insights from a source well-acquainted with the firm’s operations. It is raising capital from high-net-worth individuals and family offices, operating under the regulatory framework of rule 506b.

Presently, the office sector is under considerable scrutiny, primarily because the anticipated return of workers to their offices post-pandemic has not materialized as expected in the United States. Furthermore, the technology sector has experienced significant layoffs in recent months, leading to a reduction in office lease agreements by numerous employers.

According to Stephen Buschbom, the research director at the real estate data firm Trepp, the stress impacting the office sector has yet to manifest comprehensively within the market. This delay is partly due to the market’s anticipation of resolving the existing bid/ask gap, leading to a noticeable slowdown in recent quarters.

Buschbom elaborated on the situation: “Ultimately, the resolution for some of these properties will require capital infusion or recapitalization. However, the reluctance to commit capital stems from the uncertainty surrounding property valuations, as the market consensus suggests we are far from reaching the lowest point.”

Despite the office sector’s challenges, not all firms are hesitant to engage with it. Morning Calm Management, a fund sponsor and operating company headquartered in Boca Raton, Florida, specializing in industrial and office assets, perceives the current troubles as potential opportunities. The company has announced initiating a $500 million joint venture to target office financing deals, explicitly focusing on transactions valued at $25 million and above in larger metropolitan areas.

Mukang Cho, CEO and managing principal of Morning Calm, expressed a positive outlook, stating, “There is a tendency for valuable opportunities to be overlooked during turbulent times. Not every office loan will successfully secure refinancing or attract buyers. However, our extensive experience and expertise in owning and managing office assets across multiple states equip us with the capabilities to assess, underwrite, mitigate, and manage risks effectively in the office sector.”

Buschbom also highlighted that debt funds might show more interest in multifamily properties, anticipating that distress levels in this sector would remain minimal. Given the sector’s strong performance forecast, he suggested that any distress within the multifamily space is likely to present attractive investment opportunities.

The joint venture represents a collaboration between the firm and a global investment manager with assets under management (AUM) totalling $50 billion.

In response to changing market conditions, including reduced liquidity and elevated interest rates, Nuveen, the investment management division of TIAA, has adapted its investment strategy. While previously focusing on deals ranging from $75 million to $200 million, Nuveen is now shifting its attention to investments within the $30 million to $75 million range. This strategic adjustment aims to target alternative asset classes, such as manufactured housing and self-storage, which offer the potential for aggregation.

However, the implications of recent banking sector disruptions and preemptive cost-cutting measures in anticipation of a recession remain uncertain. Buschbom emphasized the continuing apprehension regarding commercial real estate lending’s future and its yet-to-be-fully realized impact on the market.

Furthermore, the potential effects on commercial real estate valuations, especially within the challenged office sector, remain unclear. Buschbom noted the critical nature of monitoring the market as it approaches the latter half of the year, particularly concerning the distress that may emerge following revaluations.

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