2 Groups Move Toward CRE Debt Fund Standard

August 9, 2023

The resulting index could serve as an industry benchmark, says Yardi Matrix's Paul Fiorilla.

Paul Fiorilla, Director of Research, Yardi Matrix. Image courtesy of Yardi Matrix

Two commercial real estate trade groups have taken a big step toward creating an index of private commercial mortgage debt that could be used as a benchmark by the industry.

The two groups—the CRE Finance Council (CREFC) and the National Council of Real Estate Investment Fiduciaries (NCREIF)—pooled information on 15 debt funds operated by 13 managers to create a dataset that includes historical returns and metrics including loan-to-value ratio, debt yield, debt-service coverage and average loan maturity. The funds in the aggregate have $37.2 billion of assets, including $35.5 billion of debt investments.

Last week, the groups released the first edition of what they are calling the “Open-End Debt Fund Aggregate.” The dataset is being called an aggregate and not an index because the strategies of the index’s funds encompass a mix of core, core-plus and value-add investments.

Debt funds are private and do not typically share performance information publicly. The goal for NCREIF and CREFC is to get more debt fund managers to participate and create a large and robust enough database that could be used to produce a quarterly index in the vein of the NCREIF Open-End Diversified Core Equity Funds (ODCE) index, which track performance of equity commingled property funds run by institutional managers. NPI and ODCE are widely cited industry benchmarks.

“We’re starting to get the message out there to drum up interest and build the product,” said NCREIF President Dan Dierking. “The first step is to get the word out there.” CREFC Executive Director Lisa Pendergast said: “The new aggregate adds another layer of transparency and thus liquidity to this important sector of the U.S. economy. NCREIF is a well-respected purveyor of CRE performance data and CREFC could not be happier to be a partner in this effort.”

The report released last week contains a range of information about the funds that goes through the first quarter of 2023. The average total returns for the funds, gross of fees, were 0.6 percent in the first quarter of 2023, 3.3 percent for one year, 6.5 percent for three years, 7.2 percent for five years and 7.4 percent for seven years. The aggregate’s data goes back to 2014.

Rate hikes weaken CRE loans

The impact of the Federal Reserve’s interest rate policy is evident in the data. The rapid run-up in interest rates since the spring of 2022 reduced the market value of loans originated when rates were lower. As a result, the return for the dataset’s history is heavily weighted toward income rather than appreciation. Income returns are 2.2 percent in the first quarter of 2023, 7.9 percent for one year, 7.9 percent for three years, 8.0 percent for five years and 7.7 percent for seven years. Appreciation returns are -1.5 percent in the first quarter of this year, -4.7 percent for one year, -1.4 percent for three years, -0.8 percent for five years, and -0.3 percent for seven years.

Rate increases also reduced the wellbeing of the aggregate’s loans, which primarily carry adjustable rates. The average debt-service coverage ratio (DSCR) has dropped sharply, only 1.1x of net income as of this year’s first quarter, down since peaking at 1.6x in the last quarter of 2021. The average 1.1 DSCR means that property income is only 10 percent higher than the average net cash flow of properties, which means the buffer for many loans has narrowed and increased the probability of default.

Some other metrics of the 618 loans in the aggregate: The average loan rate is 7.7 percent, the average weighted life is 2.5 years, the average debt-service coverage is 1.1x, and the average debt yield is 6.6 percent. Mezzanine loans in the aggregate have an average first risk LTV of 55.7 percent and an average last risk LTV of 73.2 percent. Just shy of 70 percent of the collateral properties are stable assets, with 27.1 percent transitional properties and 3.1 percent ground-up development.

Ares Management and PGIM Real Estate each manage two of the funds in the index. Other managers include Barings, Met Life Investment Management, Nuveen/PCCP and UBS. CREFC and NCREIF continue to recruit managers among the debt funds operating in the U.S. According to Real Estate Alert, there were 70 active debt funds in the spring of 2023, down from the peak of 82 in 2021. To participate, fund managers must offer open-end debt products, calculate quarterly returns, agree to provide requested data and agree to become a NCREIF data contributing member.

NCREIF’s mission focuses on providing transparent and consistent data, performance measurement, analytics, standards and education. CREFC represents the commercial real estate finance industry, promoting liquidity and transparency in the commercial mortgage market by establishing standards and best practices and acting as a legislative and regulatory advocate.

Currently, the industry has only one private debt fund index, the Giliberto-Levy High-Yield Debt Index, established in 2020. The GL index measures performance of high-yield debt funds.