The Rise of Private Credit in Real Estate

Similar to the mortgages given to individual homebuyers, mid-sized and large banks provide loans to finance commercial real estate deals. These banks use stringent lending criteria, including debt service coverage ratio (DSCR), loan-to-value (LTV), and loan-to-cost (LTC) ratios, along with the borrower’s creditworthiness, to determine the maximum loan amount for a project.

Sometimes a real estate sponsor or operator is unable to obtain full financing for their deal through a bank lender, creating an opportunity for a private credit lender to supply the remaining capital needed. When traditional lenders (banks and insurance institutions) tighten balance sheets, as has occurred over the past few years, a greater need for ‘private credit’ emerges.

As of 2024, with the potential for sustained higher interest rates, conditions are ideal for exploring real estate private credit strategies. In fact, private credit stands out as one of the most promising opportunities for real estate investors in today’s market.

Let’s take a closer look at what private credit entails, specifically in the context of real estate, and what accredited investors should know about this approach.

Understanding Real Estate Private Credit

Real estate private credit involves investments in debt positions where a non-bank lender (the investor) provides debt capital to a real estate sponsor or operator, usually supplementing a traditional first mortgage or senior loan.

This additional capital, combined with the total equity in the transaction, often falls short of 100% of the necessary funds to execute the business plan. Non-bank lenders or capital providers often supply the remaining funds, known as ‘gap financing.’ The term private credit typically refers to these positions held by private, non-bank lenders.

The Role of Private Credit in Real Estate Crowdfunding

Real estate private credit presents a compelling opportunity for self-directed accredited investors.

Real estate private credit, i.e., debt investments made via private capital markets, has been part of the real estate crowdfunding space since nearly the beginning. PeerStreet, an early entrant in the space, pioneered syndicated loan investments in single-family homes. Since then, other platforms like Groundfloor and EquityMultiple have also offered debt-based investments to individual passive investors at low minimums.

Given the tightening of bank balance sheets and the dislocation of rapidly rising interest rates, platforms can act as private lenders to facilitate transactions that traditional lenders are currently unable to participate in.

Why Focus on Private Credit Investments?

The goal for private credit has always been to offer investors a diverse array of real estate investment opportunities across the capital stack — through equity, preferred equity, and debt offerings — to maximize risk-adjusted return potential in any market condition.

Over the past year, the Federal Reserve’s aggressive rate hikes have significantly impacted the economy. Tech companies have slowed hiring, home transactions have decreased, and banks have reduced their financing activities.

These changes have been felt acutely in the commercial real estate market, which shifted from historic highs to a near halt in transactions. Regional banks, responsible for most commercial real estate lending, have pulled back lending opportunities following the collapse of Silicon Valley Bank. Credit committees at these banks, remembering the Great Financial Crisis, have been quick to halt new lending.

These conditions have created opportunities for private lenders to step in.

The Emergence of Private Credit

Private markets offer the advantages of transaction speed and certainty, enabling lenders to provide liquidity at the senior portion of the capital structure with favorable covenants for investors. Aside from today’s market environment, adding private credit to a 60/40 (60% stocks/40% bonds) portfolio has historically increased diversification, reduced volatility, and enhanced returns. In fact, portfolios from 1989 to 2023 with at least a 20% allocation to private credit have seen reduced volatility, increased annual returns, and an added 140 basis points of income.

Blackstone’s article last November about corporate assets and private credit’s role in leveraged buyouts highlights similar dynamics that apply to private real estate markets. There is an unmet demand for debt capital from mid-sized banks. Private real estate credit can potentially command higher lending rates to creditworthy borrowers who are secured by quality assets.

On a more fundamental level, real estate investment remains strong across various sectors and markets. The following demographic shifts and demand drivers that fueled investment during the pandemic are still largely intact:

• Employment growth continues to exceed forecasts.
• Markets with low living costs and strong job markets still attract significant net in-migration.
• Consumer confidence is high, and the services, hospitality, and travel sectors are rebounding from pandemic lows.

Private Credit as an Alternative Asset

In 2024, there has been a noticeable shift towards alternative assets, especially real estate private credit. As outlined in Campden Wealth’s November 2023 North America Family Office Report, the top priority for family offices is increasing allocations to alternatives, with real estate being the largest component of alternative assets and the second-largest overall allocation. Of note,  debt and real estate were the highest-returning asset classes in 2022.

Respondents also highlighted the importance of shortening the duration of fixed-income portfolios, a strategy individual investors can replicate with private credit opportunities offering short-term holds.

How Real Assets Coalesce with Private Credit

According to Nuveen Investment Management, the current abundance of lending opportunities offers strong relative value and attractive risk-adjusted returns. Commercial real estate debt outperformed public equities in early 2022, and real estate debt often provides higher risk-adjusted returns during economic volatility.

KKR Investment Firm’s analysis reinforces that private credit and real assets enhance risk-adjusted returns. This is especially true as stocks and bonds face headwinds in an era of elevated inflation and interest rates. By diversifying into private credit and real assets, investors can potentially achieve better risk-adjusted returns.

Middle Market Opportunities

While transaction volume is down, the Federal Reserve has indicated that it may cut interest rates in the coming year. Though lower rates might reduce the returns private credit investors can command, the timing and scale of these cuts remain uncertain.

Still, with more expensive debt capital than a year ago, many real estate investors remain cautious. The average spread between bids and asking prices remains wide.

A recent podcast episode from Trepp provides some helpful context on the landscape of maturing commercial real estate loans. As traditional lenders reduce their balance sheets, mid-sized projects and sponsors may be more underserved by traditional debt capital sources. Midsize and regional banks, previously active in middle-market lending, are now cautious, often offering terms only on the lowest-leverage deals or significantly undercutting borrowers’ requests. Quality middle-market sponsors, particularly those midway through projects, may have limited or no options for extension gap financing.

Multifamily Opportunities

Despite rising interest rates and recession fears, single-family home prices have remained stable or even increased in most markets. Homeownership remains unattainable for many potential buyers, leading to a high demand for increased multifamily housing.

The US continues to face a significant housing shortage. In many growing metropolitan areas, there is an oversupply of Class A multifamily units but a desperate need for more high-quality housing stock for moderate-income renters. These types of real estate investments are likely to be underserved by traditional debt capital, opening the way for private credit.

Considering the current market conditions — a robust economy, tight single-family market, higher rates, and a credit crunch — real estate private credit investments appear highly attractive. The demand for debt capital exceeds the supply, allowing private-market lenders to command higher rates for lending to creditworthy borrowers secured by high-quality assets at more conservative leverage levels.

We think you’ll also like:

1. Pressing the “Eject” Button: Secure a Viable Real Estate Exit Strategy First
2. Keeping It Real: A Baby Boomer’s Guide to Real Estate Crowdfunding
3. 3 Real Estate Investment Types and Cash Flow Potential

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Affordable Housing/Community Improvement Investments
2. Real Estate Investing 101 / Investing in Commercial Property
3. Ethical Issues In Real Estate-Based Bankruptcies | Valuing Real Estate Assets

This article was originally published on August 5, 2024.]

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