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Real Estate Credit: Gear Up for the Year of Transactions

  • 5 minute read
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2023 was a year of transition in commercial real estate as macroeconomic uncertainty, interest rate hikes and property value declines muted activity. We expect 2024 to be a year of transactions, creating more opportunities for well-capitalized lenders to finance deals.

The Commercial Real Estate Transition: Then and Now

The dramatic rise in interest rates triggered repricing of real estate properties and suppressed transaction activity in 2023. U.S. cap rates widened by 80 basis points over the course of the year and transaction volumes fell by 50% year-over-year (Exhibits 1 and 2). Sellers were unwilling to transact at lower values and interest rate volatility made it difficult for buyers to determine the correct entry point.

EXHIBIT 1: Real Estate Equity Cap Rates Have Widened

Line chart of real estate equity cap rates from 2010 through 2023.
Source: Green Street as of January 2024. Average cap rates shown.

EXHIBIT 2: U.S. Investment Volumes Down ~50% Year-over-Year

U.S. investment volumes in billions of U.S. dollars from 2011 through September 2023.
Source: RCA as of September 30, 2023. U.S. investment volumes.

We also saw a significant pullback from lenders, many of whom remain on the sidelines. Banks, who hold approximately 50% of outstanding commercial real estate debt (Exhibit 3), face increased regulatory scrutiny and challenges within their existing portfolios, many of which contain significant office exposure. Many private debt funds and mortgage REITs are also on the sidelines due to credit problems and the inability to source efficient senior financing. Capital markets activity also declined in 2023, with private label CMBS issuance declining 53% year over year.

EXHIBIT 3: Commercial Real Estate Loan Market: Debt Outstanding by Lender Type

A pie chart showing debt outstanding by lender type within the commercial real estate loan market.
Source: Mortgage Bankers Association, Trepp, RCA, Newmark Research.

Low transaction volumes masked the scarcity of capital in 2023, but the credit gap is likely to become more noticeable as transaction volumes pick up this year. We expect alternate providers of capital to have a significant opportunity to lend on high-quality, well-located real estate at attractive yields and terms.

What Will Drive Higher Transaction Activity in 2024?

We see several factors that should support higher transaction activity in 2024: 

  • With inflation subsiding and the Fed pausing rate hikes, we believe the decline in real estate values is close to a plateau and that the gap between buyers and sellers should narrow. 
  • Real estate equity REIT prices have rebounded and credit spreads have tightened, both of which historically have been viewed as leading indicators of a market recovery.
  • Real estate private equity funds are awash in dry powder after spending the last 18 months in wait-and-see mode. 
  • Loans will need to be refinanced, and interest rate caps for floating-rate loans will need to be repurchased, putting pressure on existing owners.
  • Many property owners are facing difficult choices in the coming years given declines in value and the need to refinance, and a growing number are likely to come under pressures to sell assets. 

Approximately $1.6 trillion in outstanding real estate debt matures in the next three years (Exhibit 4). Taking a step back, low interest rates resulted in a large amount of transaction activity and a sharp increase in prices in 2020 and 2021. Many buyers purchased at peak valuations and financed the properties with 3-year, floating-rate loans and purchased interest rate caps that are coming due this year. Given the rapid rise in interest rates over the past 18 months, many of those capital structures are now highly levered or over-levered. While we think some loans will be modified, we also expect a significant number of owners will be forced to refinance or sell.

EXHIBIT 4: Upcoming Commercial Real Estate Loan Maturities

Bar charts showing the composition of upcoming commercial real estate loan maturities from 2024 through 2026.
Source: Trepp Inc., based on Federal Reserve Flow of Funds Data
Bar charts showing the composition of upcoming commercial real estate loan maturities from 2024 through 2026.
Source: Trepp Inc., based on Federal Reserve Flow of Funds Data

We are already seeing a hint of what is to come in our real estate credit and equity pipelines, where activity is picking up. There are currently some $15 billion of loans in our real estate credit pipeline, which is up from $10-12 billion on average in 2023, and we are bringing multiple deals to our equity investment committee each week. We expect there will be significant opportunities to lend as both refinancings and acquisitions increase.

The Ongoing Need for Private Debt Capital

In 2023, U.S. government agencies, insurance companies and select private debt funds were able to provide most of the financing the market needed. That may not be possible as transaction volumes pick up, particularly because we do not expect banks to revert to their previous lending activity. After last year’s regional bank failures and decline in property values, banks’ liquidity and commercial real estate portfolios, specifically their office exposure, are under heavy scrutiny. New York Community Bancorp’s decision in February 2024 to slash its dividend stemmed from stricter capital standards after absorbing parts of Signature Bank, but it resurfaced concerns about the exposure U.S. banks have to commercial real estate.

Doing some back-of-the-envelope math, if bank lending recedes to 40% of the roughly $5.8 trillion commercial real estate debt market from 50%, it leaves a gap of over $500 billion. Who will be able to fill that gap? We do not think insurance companies or U.S. government agencies can allocate significantly more to commercial real estate given their existing exposure. That leaves CMBS and debt funds.

We expect a meaningful increase in CMBS issuance over the next several years, including $62 billion this year, up from $47 billion in 2023. We are already seeing signs of thawing in this market (Exhibit 5A). As for private debt funds, they are sitting on $39 billion in dry powder (Exhibit 5B). These are large numbers, but taken together, current non-bank financing remains insufficient to fill the void left behind by the pullback from banks.

EXHIBIT 5A: CMBS Issuance ($B)

Bar chart showing commercial mortgage-backed security issuance from 2018 through 2024 expectations.
Source: J.P. Morgan Research (accessed January 2024). Projections are unaudited and subject to change.
Bar chart showing commercial mortgage-backed security issuance from 2018 through 2024 expectations.
Source: J.P. Morgan Research (accessed January 2024). Projections are unaudited and subject to change.
 

EXHIBIT 5B: Debt Fund Dry Powder ($B)

Line chart shoring debt fund dry powder in billions of dollars through December 2023.
Source: Newmark Research
Line chart shoring debt fund dry powder in billions of dollars through December 2023.
Source: Newmark Research

The Real Estate Credit Opportunity

Across the market, we are finding that it is possible to lend at a significant discount to replacement cost and often at 50% of peak valuations, while earning low-to-mid teens gross returns on mezzanine-like exposure at loan-to-value ratios near 65%. In other words, it is possible to earn equity-like returns at a favorable position in the capital structure, and the scarcity of debt capital in the market means that these conditions should persist, in our view (Exhibit 6).

EXHIBIT 6: Lending Conditions in 2024

Bar charts showing changes in loan to value and mezzanine yields from Q1 2022 through Q4 2023.
As of December 2023. There can be no assurance that the trends described above will continue. There is no guarantee the terms mentioned herein will materialize. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment or any KKR fund, vehicle or account which, may differ materially, and may not be relied upon as such. Reflects the current market views, opinions and expectations of KKR Real Estate Credit based on its historic experience and proprietary analyses. (1) Based on U.S. light transitional multifamily loan. (2) The data presented herein is based upon the assumptions detailed. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used have been stated or fully considered. Changes in the assumptions may have a material impact on the model returns presented. Assumptions: 0.10% 1M SOFR (as of 1/4/21; Source: Federal Reserve Bank of New York), $100M loan commitment, S+3.00% and S+1.75% loan and financing spreads, respectively, 1.00% and 0.50% loan and financing origination fees, respectively. 77.5% financing advance rate. (3) Assumptions: 3.98% average 1M SOFR over 3-year assumed hold period (as of 12/6/23; Source: Federal Reserve Bank of New York), $100M loan commitment, S+3.50% and S+2.25% loan and financing spreads, respectively, 1.00% and 0.50% loan and financing origination fees, respectively. 75.0% financing advance rate.

Zooming out to look at the relative value in real estate credit, we find that current valuations look attractive relative to other asset classes given the extent to which the sector has re-priced (Exhibit 7).

The current vintage should offer a meaningful opportunity to earn attractive absolute and risk-adjusted returns by lending on high-quality, well-located assets that have been swept up in the broader reset in property values and decline in liquidity.

EXHIBIT 7: Relative Valuations across Asset Classes

Chart showing cross-asset class valuation percentiles relative to a 20 year history for both traditional and cross-asset class percentiles.
Note: S&P 500 and S&P 600 refers to NTM P/E; US Agg refer to Option-Adjusted Spread; Private Real Estate Equity refers to nominal cap rate; Private Real Estate Credit refers to mortgage spreads; Private Equity refers to exit multiples; Listed Infrastructure refers to dividend yield. Data since 1997, or since available, and as at 12/31/2023, except for Private Real Estate Credit as at 9/30/2023, Private Credit and Private Equity as at 6/30/2023; percentiles from 2002-date where available. Source: Bloomberg, Haver Analytics, Burgiss, Green Street, Cambridge Associates, Giliberto-Levy, KKR GBR analysis.