Introduction: What is Real Estate Private Credit?
Private credit is perhaps the most exciting current opportunity for real estate investors. As of 2024, with a potential “higher for longer” interest rate environment in play, the conditions are just right for real estate private credit strategies. This article explores these dynamics in depth. But first, what is private credit, what is real estate private credit, and what should accredited investors know about this strategy?
As with mortgages issued for individual homebuyers, the midsize and large-balance banking sector issues loans to finance commercial real estate transactions. Just like a mortgage, traditional banks adhere to strict lending standards to determine who to lend to, and how much. Banks factor in debt service coverage ratio (DSCR), loan-to-value (LTV), and/or loan-to-cost (LTC) — as well as the credit-worthiness of the borrower — to determine a ceiling on how much they will lend for a particular project.
Real Estate Private Credit Definition
Investments in debt positions wherein a non-bank lender (the investor) issues debt capital to a real estate sponsor or operator, generally to supplement a traditional first-mortgage or senior loan.
This amount, plus the total equity in the transaction, often amounts to less than 100% of necessary capital to successfully execute the business plan. “Gap financing” to get to 100% of proceeds is often provided by non-bank lenders or capital providers. Private credit is the term often applied to these positions, held by private, non-bank lenders.
In 2024 and beyond, we view real estate private credit as a compelling opportunity for self-directed accredited investors. This article will discuss why.
Why We Are Pursuing Investments Based on Private Credit
We have always sought to provide our investors with the ability to diversify their investments across a wide range of real estate investment opportunities across the capital stack through equity, preferred equity and debt offerings to maximize risk-adjusted return potential in any given market condition.
Simply put, the time is right and the time is now. Over the past 12 months, the Federal Reserve’s reactive antidote to persistent inflation, through aggressive rate hikes, has begun to manifest throughout the economy. Tech companies have curtailed hiring sharply, transactions in single-family housing markets have dropped, and regional banks have pulled back on financing across their traditional markets and products. The impact has been felt acutely throughout commercial real estate markets, which have whipsawed from generational highs to a near freeze in property transactions. The market is adjusting to a new normal, and the picture is still fuzzy.
The Ascent Income Fund, predicated on real estate private credit, launched in H2 2023.
Meanwhile, traditional lenders are tightening balance sheets in response to the collapse of Silicon Valley Bank and general fears of cracks emerging in the financial system. While interest rate risk now appears to be idiosyncratic to a few banks, this mini-crisis has sent tremors throughout the banking industry, directly impacting the vast number of healthy regional banks which do the majority of CRE lending. And while rates remain at historically more normalized levels, the adjustment has caused regional banks and mortgage-backed securities to pull back substantially, creating an opportunity for private lenders like EM to fill the void. Credit committees at these small banks remember the Great Financial Crisis well and have been quick to shut off new lending flows.
Private credit comes of age at a compelling time Market forces of supply and demand are aligning for private credit. Tighter lending conditions and the aftermath of Silicon Valley Bank’s (SVB) collapse caused traditional lenders to step back. With slower bank and leveraged loan growth, demand for partners in private credit is high…
…The private market offers transaction speed and certainty, allowing lenders to provide liquidity at the most senior portion of the capital structure with favorable covenants for investors. In addition to the tailwind provided by today’s market environment is the increase in diversification that has historically resulted from adding private credit to a 60/40 portfolio. From 2015 to 2023, a portfolio that added a 20% allocation to private credit reduced volatility, increased annualized returns, and added 140 basis points of income.
— Blackstone, November 2023
While Blackstone’s article may be referring mainly to corporate assets and the role of private credit in leveraged buy-outs, the exact same dynamic applies to private real estate markets. There is an unmet demand for debt capital from the mid-sized banking sector, and real estate private credit can potentially command higher rates on lending to credit-worthy borrowers (sponsors) secured by quality assets.
Real estate fundamentals remain strong in many sectors and markets. The underlying demographic shifts and demand drivers that drove real estate investment during the pandemic are largely still in tact:
- Monthly employment growth figures continue to outpace forecasts
- Markets with relatively low costs of living and strong job markets (such as Dallas) are still benefiting from significant net in-migration.
- Consumer confidence remains high, while services, hospitality, and travel continually rebound from low points during the pandemic.
Take these dynamics together, a macro picture emerges: real estate markets rife with potential, but hampered by friction in debt capital markets. In other words, there is a supply/demand imbalance in commercial real estate debt markets as major lenders pull back.
This creates opportunity for private CRE lenders.
Traditional lenders may now transact at substantially lower LTV or LTC for an equivalent property and similarly credit-worthy borrower versus just one year ago.
Charles De Andrade, Director on EquityMultiple’s Investments Team, discusses capital markets, including emerging opportunities in real estate private credit.
How Institutional Investors Are Approaching Private Credit
EquityMultiple allows individual investors to mirror the asset allocation strategies of family offices and institutional investors. Hence, we find it instructive to monitor trends in institutional investors’ portfolio strategy.
Heading into 2024, there was a clear shift toward alternative assets (like real estate) in general, and particularly toward real estate private credit.
From Campden Wealth’s November 2023 North America Family Office Report:
- “Adding more to alternatives” is the #1 stated imperative of surveyed family offices going forward.
- Real estate makes up far and away the largest chunk of alternative assets among respondents, and is the second largest allocation overall (behind developed market equities)
- “Private debt” and “real estate” were the two highest returning asset classes in 2022 among respondents.
Interestingly, respondents also flagged “shortening duration of fixed income portfolio” as the highest priority in terms of proactive management in today’s uncertain market. This is a strategy individual investors can potentially mirror on EquityMultiple with the Ascent Income Fund and other private credit opportunities, as well as with Alpine Note positions that carry 3, 6, or 9 month holds.
Per Nuveen, “It is an opportune time to add commercial real estate debt to a real estate equity or multi-asset portfolio given the abundance of lending opportunities offering strong relative value and attractive risk-adjusted returns.
CRE debt outperformed public equities in the first half of 2022. The real estate sector’s relatively strong performance in 2022 is likely to have pushed real estate above the target allocation of many institutions, causing a pullback in real estate transaction volumes in the second half of the year. Historically, real estate debt often provides higher risk-adjusted returns than real estate equity at points such as this in the cycle, as real estate debt provides stable capital returns during times of economic volatility.”
Recent research by KKR drives home another point: real estate private credit may hold additional appeal at a time when the classic 60/40 portfolio faces headwinds.
- Stocks and bonds are more closely correlated now in this era of elevated inflation and rates, undermining the “hedging” benefit of bonds.
- With real yields on bonds challenged, and potential stock market volatility, the potential “equity-like returns” of real estate private credit may be all the more appealing.
KKR’s analysis shows the potential for private credit and real assets to move investors up the “efficient frontier” — in other words, by diversifying into private credit and alternatives like real estate, investors can potentially enhance risk-adjusted returns.
The Opportunity Is Most Robust in the Middle Market
Transaction volume is down across the board. The Fed has continued on its path of rate hikes as the data picture is mixed, and they are erring on the side continuing to tighten. The market expects 0.25% increase at the next meeting where perhaps they can pause. However, forecasting the terminal rate remains a speculative exercise. With debt capital so much more expensive than a year ago, many real estate investors remain “pencils down.” With such fluidity in capital markets, the average spread between bids and asking price remains wide.
A recent episode of the Multiple Perspectives podcast touches on the current landscape of maturing CRE loans.
As traditional lenders de-leverage and shore up balance sheets, less institutional CRE projects, and “sub-institutional” sponsors and operators, may be most acutely underserved by traditional sources of debt capital.
Midsize and regional banks are more skittish and leery of scrutiny than they were even two months ago. The same banks that previously lent extensively to middle-market sponsors and developers may only issue term sheets on the largest, lowest leverage deals they see or undercut borrower’s request across terms. What’s more, quality middle-market sponsors who are midway through a project (in construction phase, for example) and previously took on floating rate or limited term debt may have few or no choices for extension gap financing.
Update, Mid-2024
Federal Reserve Decisions and Comments
As of mid-2024, the Federal Reserve’s monetary policy continues to play a crucial role in shaping the capital markets. Recent comments from the Fed have suggested a more cautious approach towards future interest rate hikes, with a possibility of a few more increases before stabilizing. This is in response to persistent inflationary pressures despite previous aggressive rate hikes. The Fed’s commitment to controlling inflation means that interest rates are likely to remain elevated for the foreseeable future, which has significant implications for private credit and real estate markets.
Volume of Loan Maturities
The volume of commercial real estate (CRE) loan maturities coming due in the near term is substantial. According to recent market reports, there is an estimated $500 billion in CRE loans set to mature over the next two years. Many of these loans were originated during periods of lower interest rates, and refinancing them in the current higher-rate environment presents challenges. Borrowers may face higher debt service costs, stricter lending standards, and reduced availability of traditional bank financing. This scenario creates an opportunity for private credit lenders to step in and provide necessary capital to credit-worthy borrowers who may not meet the tightened criteria of traditional banks.
Market Dynamics and Opportunities
- Interest Rate Environment: The “higher for longer” interest rate environment continues to create a favorable scenario for private credit investors. Higher rates mean private lenders can command better returns on their investments, especially when traditional lenders pull back from the market.
- Credit Availability: With regional banks still cautious and adjusting their balance sheets post the collapse of Silicon Valley Bank and other recent banking stresses, there is a notable pullback in lending. This credit crunch is particularly pronounced in the middle-market segment, where sponsors and developers are finding it increasingly difficult to secure financing. Private credit can fill this gap, offering flexible and timely capital solutions.
- Economic Indicators: Employment growth remains robust, and markets with lower costs of living continue to see strong in-migration, supporting demand for multifamily housing and other real estate sectors. Despite economic volatility, consumer confidence remains high, and the service sector, including hospitality and travel, is rebounding, creating a stable backdrop for real estate investments.
- Institutional Investment Trends: Institutional investors are increasingly allocating to alternative assets, including real estate private credit, seeking higher yields and diversification benefits. Reports from family offices indicate a strong preference for increasing allocations to private debt and real estate, reflecting confidence in the asset class’s performance even in uncertain market conditions.
- Potential Rate Cuts: There is speculation about potential rate cuts in the future, but the timing and magnitude remain uncertain. Any reduction in interest rates could impact the rates private lenders can charge, but the current environment still presents a strong case for private credit due to the existing supply-demand imbalance in debt capital.
The current capital market conditions underscore the attractiveness of real estate private credit as an investment strategy. With traditional lenders pulling back, higher interest rates prevailing, and significant loan maturities approaching, private credit provides a compelling opportunity for investors to achieve favorable risk-adjusted returns. The ability to act swiftly and offer flexible terms positions private lenders to capitalize on the gaps left by traditional banking institutions, making this a timely and lucrative investment avenue.
Opportunities Intersect in Multifamily
Despite rising interest rates and recession fears, single-family home prices have not slowed considerably in most markets. After a brief dip following the aggressive rate hikes, average home values have continued their steady climb. Home ownership remains as unattainable as it has ever been for many would-be homeowners, to a multi-decade extreme. The U.S. remains structurally undersupplied in terms of housing stock. In many growing metros, Class A multifamily has been oversupplied. Broadly, the United States desperately needs more and improved housing stock for moderate-income renters. These are precisely the types of real estate investment that may be underserved by traditional debt capital for the foreseeable future.
Taken together, [the factors in today’s market: a robust economy, a tight single-family market, higher rates, and a credit crunch] make a strong case for real estate private credit investing: an excess of demand over supply for debt capital, and high prevailing rates. This means that private-market lenders can command higher rates for lending to more credit-worthy borrowers, secured by higher quality assets, at more conservative overall leverage. In other words, potential for outsized risk-adjusted returns.
— EquityMultiple 2024 Outlook Whitepaper
That said, there’s a potential softening of fundamentals on the horizon. With small-balance CRE lenders and regional bands on the sidelines, there is an opportunity gap for financing sources who are able to provide flexible, alternative private credit at very attractive-risk adjusted returns. We see an exceptional opportunity to provide private credit solutions to the middle market. In so doing, we believe we have a unique opportunity to deliver our investors strong, diversified, risk-adjusted returns and attractive income.
While cost of capital is heightened, the investment thesis for multifamily is very strong in many markets. Hence, the risk-adjusted returns potential for lending on multifamily may be especially appealing.
EquityMultiple’s Approach to Private Credit Investments
EquityMultiple has offered real estate private credit investments since 2015. Historically, the majority of these investments have been individual loans into distinct properties. In some cases, these investments are serving directly as debt capital for borrowers (sponsors) and in some cases EquityMultiple investors are participating in the syndication of preexisting loan. EquityMultiple has offered mezzanine debt, senior debt, and other structures over the years within the ‘Earn’ investment pillar.
The Ascent Fund is the flagship offering within the Earn pillar, and will be available in perpetuity, with EquityMultiple investors able to reinvest or reallocate from Alpine Notes or exits of other investments. The Ascent Income Fund, as a diversified real estate private credit investing vehicle, is timely for the reasons stated above. Learn more about the potential return profiles of combined Ascent+Alpine portfolios>>>
In all cases (managed funds or distinct private credit investments) EquityMultiple’s Investments Team practices its hallmark level of rigor in asset selection. Among other factors, our originators will look at:
- The credit-worthiness of the borrower (sponsor)
- The entire capital structure and leverage relative to return potential
- The DSCR and borrower’s ability to cover debt service, even in adverse circumstances
- The quality of the asset and health of the market
For questions, don’t hesitate to reach out to ir@equitymultiple.com.
FAQs on Real Estate Private Credit
Q: What is real estate private credit? A: Real estate private credit refers to privately negotiated loans between borrowers and non-bank lenders, specifically tailored for real estate transactions.
Q: Why is private credit becoming more prominent in real estate? A: The retreat of traditional banks from lending, due to regulatory and economic pressures, has created opportunities for private lenders to fill the void, offering more flexible and tailored financing solutions.
Q: What types of opportunities exist within real estate private credit? A: Opportunities range from specialty finance and senior corporate loans to commercial real estate lending, encompassing both performing and nonperforming credit.
Q: How do private credit investments compare to traditional fixed income? A: Private credit may offer higher yields and increased investor protections through negotiated terms and covenants, albeit with higher risk and illiquidity compared to traditional fixed income.
Q: What are the risks associated with private credit investing? A: Risks include creditworthiness of the borrower, capital stack seniority, and interest rate fluctuations. Investments in private credit are also subject to illiquidity risk and may involve speculative practices.
For accredited investors exploring the realms of commercial real estate, the surge in private credit opportunities presents a compelling avenue for diversification and potential returns. As the landscape continues to evolve, staying informed and agile will be key to navigating this dynamic sector successfully.
