BX Blackstone Inc

By Peter Grant 

The state of Kentucky's $16 billion pension fund has long invested a portion of its assets in commercial-real-estate funds managed by private-equity firms, but lately it is more interested in funds that make loans than those that buy property.

That's because, like many other big investors, Kentucky Retirement Systems is wary of the eight-year run of rising commercial-real-estate values. If prices fall, the thinking goes, it is less risky to be a lender than an owner of a property.

"Prices are really, really stretched," said Rich Robben, interim chief investment officer of the Kentucky pension fund. "We feel, at this point, we're happy to lend to you and let you take the haircut."

Last year, debt funds raised $20.4 billion, up from $12.2 billion in 2015, according to data firm Preqin. Big real-estate fund managers Blackstone Group LP, KKR & Co., Kayne Anderson Real Estate Advisors, Och-Ziff Capital Management Group LLC and Mesa West Capital all closed a debt fund in the past year or started raising one.

Private-equity firm debt funds have financed much of the residential, retail and office redevelopment that has taken place in downtowns around the U.S. as millennials flock to urban centers. In New York, debt-fund loans increased 60% from 2014 to 2016, according to a study by CrediFi, a real-estate data and analysis firm.

"There's a lot of high-quality real estate aside from 100% occupied trophy buildings in Midtown Manhattan," said Ryan Krauch, principal at Mesa West.

Examples of recent deals by Mesa West include the $210 million loan it made last year to the owner of Chicago's John Hancock Center. Before the 2008 financial crisis, a bank probably would have made that loan, Mr. Krauch said. But most banks steered clear because some tenants in the building are new and are still in a free-rent period, he said.

"The competitive landscape disappeared," Mr. Krauch said.

For investors, debt is considered less risky than equity because if values plummet, debt-fund managers can foreclose, making it more likely they will preserve their principal investments. Equity owners, meanwhile, could suffer losses or get wiped out.

For example, say an equity investor borrows $75 million from a debt fund to buy a building that costs $100 million, putting in $25 million of equity. If that building's value falls to $85 million, the equity investor has lost $15 million, but the debt fund will still get repaid its entire $75 million.

At the same time, many debt funds are posting attractive returns, from percentages in the high single digits to the midteens, depending on their lending strategies. The prospect of such gains in a low-interest rate world is like catnip to today's yield-hungry investors -- particularly pension funds worried about fulfilling commitments to future retirees.

Some debt-fund managers said they can produce such results by using leverage to boost returns. In other words, they may lend, say $75 million at a rate of 5% but borrow $50 million of that at a rate lower than 5%. That way, their return is greater than 5%.

But the mushrooming of debt funds has prompted some real-estate experts to sound warnings. None of the critics are saying a crash is on the way. But some are advising investors to keep their eyes open to the risks the funds are taking.

"There's a perception that when you say debt, it implies safety," said Michael Stark, co-head of Park Hill Real Estate Group, which advises private-equity firms on their capital-raising efforts. "But if the collateral you're lending on is not a stabilized asset, there's still some underlying risk that needs to be priced accordingly," Mr. Stark said.

Commercial real-estate values collapsed after the financial crisis and have rebounded in many places to record values in recent years. But the prices have plateaued in many markets, sparking concern among investors that they might not be getting adequately compensated for the risk of owning equity.

Debt-fund managers say they are able to generate high yield partly because traditional lenders haven't regained their precrash appetite for making commercial real-estate loans, especially those that finance new construction and fixer-upper projects. That makes it a seller's market for the loans they provide, the fund managers say.

Big banks are limited in part by new regulations imposed by the 2010 Dodd-Frank financial overhaul that make it more attractive to focus on first mortgages and steer clear of riskier loans.

Critics of debt funds question whether the funds will be able to keep up such returns as more pile in and compete with one another. They also point out that banks could get more aggressive if the Trump administration succeeds in easing regulation.

"Will the opportunity [offered by debt funds] be impacted by any changes in regulation?" asked Mr. Stark of Park Hill.

Write to Peter Grant at peter.grant@wsj.com

(END) Dow Jones Newswires

March 14, 2017 05:44 ET (09:44 GMT)

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