Demand for high-yield-debt funds appears to have softened in the past year.

The amount of equity raised by active closed-end vehicles is down for the first time since 2013, according to an annual review of high-yield real estate funds by sister pub­lication Real Estate Alert. Of the 533 funds identified by the survey, 74 invest pri­marily in debt — the most ever. But the number of fund operators in the mar­ket dropped to 65, from a record 70 last year (see list­ing on Pages 9-11).

After peaking at $54.9 billion a year ago, the aggregate equity held by debt funds plummeted 18% to $45 billion. The total amount invested by those vehicles also fell — to $11.4 billion, from $14 billion.

To be sure, the universe of debt funds is still large from an historical perspective. Before 2017, the total amount of equity raised never exceeded $40 billion. But after seven years of steady growth, the market clearly has slowed — and the coro­navirus pandemic could further suppress investor demand.

“There has been a massive proliferation of debt funds over the previous three years,” said Bill Thompson, senior managing director in Evercore’s private-capital advisory group. “So even before the coronavirus, LP interest was slowing. ‘Not another debt fund’ was the refrain.”

Thompson predicted, however, that investors will continue to back managers offering differentiated strategies, whether defensive or opportunistic.

Since the financial crisis, nonbank lenders have come to account for an increasing share of the commercial-mortgage sector. Originations by nonbanks amounted to 41% of the mar­ket in the fourth quarter, up from 29% a year earlier, according to CBRE.

Among high-yield vehicles, the total amount of dry powder they have to invest dropped 18%, to $33.7 billion from $40.9 billion a year earlier. That’s a potentially worrisome sign for borrowers at a time when commercial MBS lenders have retreated to the sidelines and balance-sheet lenders are proceed­ing with extreme caution.

Market pros expect debt funds that use leverage sparingly will remain active and even thrive amid an economic downturn, while highly leveraged vehicles will struggle.

“No investment committee has underwritten this kind of shock — none,” said Walter Stackler, founder of New York placement agent Shelter Rock Capital. “The groups that do well in this environment will be well-capitalized and have multi-disciplinary teams that can effectively manage the restructur­ings that are bound to happen. Managers with in-house direct equity expertise will have an advantage.”

Kevin Miller, chief executive of Los Angeles-based fund manager Thorofare Capital, said operators that borrow heav­ily to boost their returns or rely on CMBS programs to recycle capital will suffer in the months ahead. “Those groups that are overleveraged, they’re the ones who are going to get hurt. And being under-levered is finally going to pay off for groups like ours,” Miller said.

Multiple sources said banks that offer warehouse lines or repurchase-agreement financing to debt funds soon may pull back — either by freezing the facilities or raising rates to unworkable levels.

Real Estate Alert’s review found that just 17 debt funds held a final close last year — the lowest number since 2016. The peak was 28 in 2017.

Alan Pardee, co-founder of New York placement agent Mer­cury Capital, said foreign investors lately have been deterred by the high cost of currency hedging. “The one thing that has been different was that hedging costs to the dollar made U.S. debt funds a bit harder for international investors to invest in last year,” he said.

Real Estate Alert tracks active closed-end funds that invest in properties, debt, or both, and shoot for returns of at least 10%. The 533 vehicles identified in this year’s review are seek­ing to raise $411 billion of total equity. The debt-fund compo­nent has an aggregate equity goal of $66.1 billion, or 16% of the total — the lowest level since 2014.

Vehicles are considered active if they are still raising capital or if they have already held final closes but have invested less than 75% of their equity. So each year, a rotating group of funds is counted. Twenty-six debt funds were added this year and 25 fell off the list.

One that dropped off was a $4.8 billion Blackstone vehicle, Blackstone Real Estate Debt Strategies 3. The removal of that fund is part of the reason that the total amount of equity held by high-yield debt funds fell by as much as it did.

The review classifies funds as debt vehicles if they intend to invest at least half of their equity in the origination of loans or in the acquisition of loans or debt securities. The other 459 high-yield real estate funds primarily target property pur­chases, but 224 of them also can buy or originate debt. So 42% of the fund universe overall can invest in debt to some extent.

Funds are included if they raise capital at least partly from U.S. investors or invest mostly in U.S. commercial real estate. Joint ventures, separate accounts and open-end funds are excluded.