How Far Will You Go?

Is the window of opportunity closing on subordinated real estate debt investments? Given the sheer weight of capital that has entered the U.S. commercial real estate debt space in the past few years—and the increasing investor appetite for mezzanine, B-piece, CMBS and preferred equity strategies—it’s certainly a fair question for LPs to be asking their GPs. The fear stems from the yield compression of the past four years and, more specifically, the past 12 months, as competition for deals has increased. Spreads for mezzanine debt were roughly 200 to 300 basis points higher in 2010 than they are today, according to Jack Taylor, a managing director and head of global debt at Prudential Real Estate Investors, who we interviewed in this special report. For Taylor, it has prompted nostalgia for the opportunities of four years ago. Yet to argue that the opportunity is over—or that the U.S. debt market is oversupplied and mispriced, as Ethan Penner, former president of CBRE Capital Partners, argues—is, for many, oversimplifying matters. With an estimated $1.4 trillion in commercial mortgages maturing between 2014 and 2017, including roughly $346 billion in CMBS legacy loans, the wall of maturities facing the industry is immense. Improving fundamentals and lending liquidity will mean much of the maturing debt is dealt with rationally. Fire sales were not commonplace in the depths of the Great Recession and are certainly not going to be in the run-up to 2017. But real estate fundamentals are not improving evenly, or universally. There lies the opportunity for higher-yield debt managers. Institutional investors should now be asking their debt-focused managers how far they will go to hit their targeted returns. How far are they willing to stray from their mandate by pushing into riskier parts of the capital stack or moving away from their core competencies? Competition among debt players has increased dramatically in the past eight years. Between January and August of 2013, 37 percent of all real estate capital raised for closed-ended, commingled funds targeted a debt and mixed-debt-and-equity strategy. In 2006, according to a survey done by Preqin, that figure was just 7 percent, representing a more than five-fold increase in the number of funds targeting debt strategies. Together with new entrants to the field, existing players raising ever-larger funds, and the market’s improving fundamentals and liquidity, yields are naturally compressing across the capital stack. What remains to be seen is whether this race for yield will push managers away from their stated mandates, as they try to meet their original return objectives. Or if they will willingly hand back their LPs’ capital, if the market moves beyond the risk appetite of their investors.