The global financial crisis of the 2000s led many central banks to reduce interest rates to levels not seen for decades in advanced economies. Consequently, with the availability of cheap debt, many real estate funds substantially geared up their portfolios. Debt both at portfolio and fund-level enhanced returns and also amplified the amount that sponsors could deploy into assets, even when fundraising markets meant raising larger funds was not itself feasible.
The decision by central banks to raise base interest rates from mid-2022 onwards in order to combat surging inflation post-Covid forced many sponsors to re-evaluate their funds’ level of gearing. In many instances, real estate managers found that when they had taken out loans, such indebtedness had not been accompanied by interest rate hedging (on the basis that the sudden rise in interest rates had not been foreseen, and in a number of cases because lenders had neither required nor argued for such protection). The increased price of debt eroded part of the rationale for the leverage in the first place. New debt was hard to come by and mandatory hedging required by some lenders (in some case, as a new policy requirement, and in a volatile market) meant that cost of debt simply was no longer as attractive. Consequently, in the absence of any commercially viable hedging arrangements and the increased margin on debt, many managers sought to pay down gearing on the portfolio. Many real estate funds approached limited partner advisory committees to inform them of changes to funds’ leverage policies, seeking approval to deviate from agreed gearing targets on a temporary basis. Many investors were initially supportive, but increasingly have begun to question the level of returns without portfolio-level gearing.
The first half of 2024 has proven challenging for new real estate fund launches. Constraints on stock availability, along with the unwillingness of investors to indulge the yield delay required for forward funding and development has meant that conditions have not been favourable. However, continuing elevated interest rates (against pre-Covid levels) have also played a significant role in depressing fundraising and deployment. Earlier this year sponsors spoke hopefully of anticipated rate cuts by the major central banks, such as the Federal Reserve, the European Central Bank and the Bank of England (with some speculating that the Bank of England or the ECB might be bullish and front-run the Fed on a rate cut). With inflation quickly approaching the Bank of England target rate of 2% and with many advanced economies seeming to have achieved a “soft landing” post Covid, many were hopeful of an imminent cut. The announcement in May of a “surprise” UK general election, however, caused many economists to defer predictions of rate cuts form June to November (whilst some are predicting a 50-basis point cut in August).
The continued difficulty of obtaining debt at commercially viable prices continues to disrupt fundraising and deployment for real estate funds. The response has been varied. Some managers are struggling to raise capital at all, as investors question whether they can obtain satisfactory returns without substantial asset-level leverage. Others that have raised capital are holding off on deployment until they can obtain financing on a floating rate that is trending downwards. Others are being forced to deploy through investor pressure and either not gearing at all (but intending to repay fund equity once leverage becomes available at sensible rates) or deploying modest levels of borrowing through more conservative revolving capital facilities. Longer term, many real estate managers seem to be looking at the bond markets again as a way of raising debt finance at commercially viable rates.
2024 has so far been a damp squib for fundraising and real estate fund launches. However, with rate cuts anticipated for later in the year, many managers will be gearing up over the summer with a view to a Q4 launch (preferably ahead of any potential slowdown ahead of the US election).
By Steven Ward, head of funds at London-based law firm Squire Patton Boggs
