Flexible capital can fortify a recovering real estate sector

2 April 2024

Investors flocked to the safe haven of real assets as the COVID-19 pandemic subsided, also taking advantage of ultra-low interest rates, but they now face a less enticing climate. Rising interest rates and a stalemate in dealmaking due to asset valuation uncertainty are creating difficulties, but opportunities are forming for investors in the latter half of 2024 as the macroeconomic environment begins to stabilise.

Numerous real estate businesses are looking to reinforce their capital structures as they contend with spiralling floating-rate loans, many of which are due to mature in the next couple of years. Flexible capital, in the form of preferred equity and other options, is helping to buttress the sector.

Economic volatility and a rise in the cost of borrowing has led to less steady balance sheets

A challenging macro environment

The European Central Bank warned in November 2023 that the eurozone real estate sector was facing escalating losses and that some property companies were struggling to support their debts,1 posing a further threat to investors and lenders.

Over in the US, the rise of interest rates and declining occupancy levels have also knocked market confidence. New York Community Bancorp revealed in February this year that it had suffered significant losses on loans linked to commercial property.2

Fund raising for closed-end real estate funds has plunged, yet $US402 billion of dry powder for investment in global commercial real estate was still waiting on the sidelines as of October 2023.3 Despite the availability of capital, uncertainty over asset valuations has frozen transactions with buyers looking for discounts and sellers unwilling to concede to price cuts. European commercial real estate deals plummeted by 47 per cent in the first half of 2023, compared with the same period in 2022.4 In the US, transaction volume is down by 55 per cent from the 2021 peak and is the slowest year of activity since 2013.5

While the outlook ahead is uncertain and continues to evolve, investors that leverage flexible approaches to capital, while maintaining a long-term strategic vision, will find opportunities to thrive.

Global real estate capital flows ($US) 2007-2023

Seeking alternative sources of capital

This testing period is leading real estate businesses to shore-up their debt and equity positions, often looking to multiple sources of equity investment and debt finance or a provider that can offer solutions across the capital structure.

There is frequent and increasing demand for us to plug the gap between where the senior banks stop lending and where equity begins investing.”

Alexi Antolovich
Global Co-Head Real Estate
Macquarie Capital Principal Finance (London)

Last year, Blackstone Group refinanced its Danish residential portfolio with an approximately £791 million loan from Danish financial institutions and additional capital from Macquarie Capital and Viga Real Estate.6

Jackie Hamilton, Global Co-Head Real Estate, Macquarie Capital Principal Finance (New York) agrees that there are widespread gaps to fill:

Buyers and sellers haven’t reached consensus on what value is, and significant amounts of debt are due. That dynamic is creating demand for ‘gap capital’ such as mezzanine debt or creative preferred equity structures to help refinance maturing debt and/or provide additional funds for carry costs.”

Jackie Hamilton
Global Co-Head Real Estate
Macquarie Capital Principal Finance (New York)

A growing demand for recapitalisation

With a wave of loan maturities due in 2024 and 2025, many real estate businesses will need to reassess their capital structure even more urgently, especially with banks becoming more risk averse. Some $US929 billion in commercial mortgages will mature in 2024, imposing more hardship on the sector.7

Businesses will need to accept a higher cost of capital, which in turn means there will be more distress. “There’ll be cases where people just need capital to maintain a real estate asset, so we’ll see significant demand for flexible capital solutions,” says Hamilton.

The development sector is financed with shorter-term, floating rate construction debt that has become difficult to refinance as completion of lease-up and business plans take longer, and numerous banks are reducing their appetite for non-stabilised assets.

Inflation has led to an increase in construction costs and coupled with elevated funding charges, which is piling further strain on the development sector and even preventing the commencement of new developments.

Understanding geographical disparities

Further complications lie in fluctuating appetites for certain types of property and particular geographical locations. The chasm between primary and secondary markets has widened with those properties in the latter segment, especially in Europe, now facing an uncertain future.

“This has meant that there’s been a huge shift, or a flight to quality,” comments Antolovich. “Where landlords have high quality buildings in good locations, the occupancy is very good, but the secondary stock has been hurt, particularly in the office sector.”

Antolovich currently sees the UK, Ireland, Germany and Scandinavia as primary markets for Macquarie Capital in Europe: “We’re being quite cautious about where we invest and lend our capital. We are focused on geographies with good rule of law and sponsors that are capitalised with a solid track record, so that if things don’t go to plan, we can be supportive of each other to ride through any volatility.”

Earlier this year, Macquarie Capital provided a £188 million senior debt facility for a Cain International-led consortium’s refinancing of The Stage residential tower, a landmark development in Shoreditch, London.

In the US, Macquarie Capital is looking at high-quality New York residential assets because they attract significant levels of international capital and valuations are generally stable due to the scarcity of new build sites and difficulty in finding financing.

In December 2022, RXR, Macquarie Capital Principal Finance and the Qatar Investment Authority closed a $US261 million preferred equity investment in the acquisition of One & Two Sutton Place and One East River Place in Manhattan, New York.8 This investment occupies what traditionally would have been spoken for by a senior debt investor prior to the increased interest rate environment.

More recently, Macquarie Capital Principal Finance provided a $US170 million senior debt facility to a joint venture between an undisclosed leading private equity firm and Centurion Real Estate Partners. The loan will refinance 55 unsold units at the newly redeveloped 108-unit residential building on Manhattan’s Upper West Side.

Outside of the residential sector, the team has also found REITs and other real estate owners looking to shore up liquidity. The group recently provided a low-leverage $US62 million senior mortgage against the Ritz-Carlton Reserve located in Dorado Beach, Puerto Rico, to provide liquidity to a hospitality REIT against an asset that had previously been un-levered.

According to Hamilton, the sunbelt states are also preferred destinations for investment after the pandemic accelerated population movements to regions with warmer climates, a lower cost of living, lower taxes and growing employment prospects.

For developers, investors and lenders, this creates yet another level of complexity. Ensuring the continued relevance and attraction of legacy buildings, while being at the centre of growth markets, will require a range of capital requirements. In a period of such uncertainty and with an elevated cost of debt, finding flexible sources of capital will be vital to maintaining the health of real estate balance sheets.

“We anticipate that some of the volatility in the markets will present us with opportunities to invest up and down the capital structure, both by ourselves and with some of our clients,” says Antolovich. “We believe the biggest opportunity of 2024 will be to provide plug financing to sponsors who need to bridge through refinancings. Macquarie Capital is perfectly set up to invest in these situations given our access to the Group’s balance sheet, allowing us to make decisions and deploy quickly.”

Financing the revitalisation of a Waikiki Beach hotel

Macquarie Capital’s investment will enable Dovetail + Co. (‘Dovetail’) to enter the Hawaii hospitality market through its acquisition of a prime piece of Waikiki Beach real estate.