Private debt funding in real estate: a new era?
In the dynamic world of real estate, the UK is undergoing a transformative shift driven by the rise of private debt.
Traditionally, banks and institutional lenders held sway in providing financing for property ventures. However, in recent years, the emergence of private debt funds and alternative lenders has injected a new dimension into real estate financing. So, what are the factors propelling this surge in private debt within the UK’s real estate sector, how is its profound impact being felt, and how is this not all bad news for traditional lenders?
A shift in real estate financing
The real estate sector, long reliant on conventional banking channels, has experienced a notable disruption with the surge of private debt. Multiple factors have converged to drive the surge of private debt in the UK’s real estate domain. Following the global financial crisis of 2008, Trussonomics and the high inflation-high interest rate environment in which we now live, banks have become more risk-averse and stringent in their lending practices. Private debt funds have capitalised on this demand by offering real estate developers and investors access to alternative financing sources with competitive returns.
On the one hand, investors are seeking higher yields beyond those offered by traditional investment avenues. The typically floating-rate nature of real estate debt makes it attractive to investors, resulting in significant capital inflows.
On the other hand, banks are tightening lending criteria and withdrawing from certain types of riskier lending all together. This has paved the way for non-traditional lenders to step in and fill the void.
The evolution of technology has also played a pivotal role. Fintech platforms have streamlined the lending process, facilitating faster loan approvals and enabling alternative lenders to effectively assess property risks. This has democratised access to capital, allowing a broader range of players to participate in real estate ventures. It’s also been beneficial on the investor side; platforms have enabled a much wider variety of investors (and a larger number on each transaction) to participate in loans. Previously, the costs of managing these investors would not have been worthwhile for private debt originators.
How developers can reap the rewards
Private debt has increased the availability of tailored financing options. Unlike traditional banks, private debt funds often specialise in specific property types or niches, enabling developers to secure loans that are closely aligned with the unique attributes of their projects without the multiple rounds of credit committees. This is what gives private debt the edge; bespoke financing combined with swift execution.
Furthermore, private debt has proven particularly beneficial for smaller developers and property investors. These stakeholders often face challenges accessing funding through traditional avenues due to their size or limited credit history. Private debt’s flexibility and less rigid underwriting criteria provide them with a lifeline to finance projects that might otherwise have remained unrealised.
Borrower due diligence
Although whether borrowing from a bank or private lender might appear to give rise to the same considerations, there are certain idiosyncrasies specific to private lenders which could have disastrous consequences for a borrower. The two most important are:
- The ability to fund. There are typically very few concerns about whether a bank is able to fund future drawdowns; they are typically well capitalised. Private lenders will rarely have equivalent balance sheets but will they be likely to continue to fund loans? Have they used a special purpose vehicle for a loan which has very little assets? Inability to fund could lead to borrowers having to refinance the debt in full which is expensive and time consuming.
- Managing a default. Particularly after the bad publicity achieved by RBS’ GRG team following the global financial crisis, banks tend to be reluctant to enforce. Private lenders don’t have the same regulatory considerations and could therefore be more aggressive when the going gets tough.
So how can a borrower mitigate these risks? Due diligence is key; picking private lenders that are well-capitalised or have access to significant capital. Many will also work harder than banks to ensure they are repaid in full without resorting to enforcement if nothing else to ensure that their loan is protected. Checking their track record is vital.
Challenges on the horizon
The lack of standardised reporting and transparency in the private debt market also poses risks. Investors may struggle to accurately assess the risk associated with various loans, potentially leading to misinformed investment decisions. Ensuring adequate disclosure and reporting mechanisms are in place will be pivotal in maintaining market integrity.
There is also an increase in the leverage offered by private debt. Some private funders are requiring very little equity to be injected by the borrower and whilst this enables a wider variety of borrowers to access projects, it also comes with risks. Having little skin in the game means when the going gets tough a borrower might not be willing to invest the time to resolve issues, as they stand to gain very little, if anything, if a solution is achieved. It’s critical for private lenders and their investors to understand these risks and balance them with the rewards available.
As private debt gains prominence in the UK’s real estate sector, regulatory oversight has become a priority. As things stand, lending against commercial real estate is entirely unregulated. Although borrowers in this space are typically very sophisticated, striking the right balance between fostering innovation and protecting stakeholders is paramount. Regulatory bodies are increasingly focused on creating a framework that ensures responsible lending practices, risk mitigation, and adequate investor protection.
Can private debt and bank debt co-exist?
It’s not all bad news for banks and other traditional lenders. Investors in private lenders are typically less interested in the low leverage-low return tranche of a piece of debt – a space banks are very happy to operate in. This is presenting both banks and private lenders an opportunity to co-exist.
Those banks who are ahead of the game are partnering up with private lenders and offering them leverage. The bank takes the low loan to value tranche leaving the private fund to take the riskier first loss tranche. Given the low risk profile for the bank, they are getting increasingly comfortable with allowing the private debt provider to originate transactions and manage the relationship with the borrower.
This is potentially a win-win for all parties. The borrower only deals with one counterparty but with more leverage than it could get from a bank, the private debt provider can do bigger ticket sizes and offer higher returns to its investors and the bank is able to fund transactions on a last-loss basis without having to originate or manage the loan. The difficulty of course is that it takes time to build relationships between banks and private lenders and it’s not always the case that each of them will be a perfect fit for each other.
Harnessing regulation to unlock transformative potential
The surge of private debt in the UK’s real estate sector has ushered in a new era of financing possibilities. As alternative lenders and private debt funds carve out a significant role, developers and investors are gaining access to innovative financing solutions that cater to their unique needs. While the advantages are evident, regulatory vigilance is necessary to ensure that the sector remains resilient and transparent. By addressing challenges related to risk assessment, transparency, and market stability, the UK can harness the transformative potential of private debt to reshape its real estate landscape for the better. If banks and debt funds can work together to get the formula right, there are potentially benefits to be reaped for the industry as a whole.
This article first appeared in Institutional Real Estate Europe in September 2023 – see here (paywall).