Reasons to invest in Private Real Estate Credit

Over time, the advantages of investing in Private Real Estate Credit (high-yield debt) have essentially remained the same: Attractive relative value, equity cushion to absorb unforeseen asset stress, real asset collateral to help hedge against inflation, floating rate/ short duration to avoid major interest rate driven markdowns, and returns comprised primarily of income.

Private real estate debt funds have largely experienced steady growth, as these advantages have spurred increased allocations. Looking forward, debt investments made in the next couple of years should potentially benefit from underwriting post inflation valuations, higher yields, and better visibility on the post-COVID landscape. The equity buffer/cushion and high current return are gaining a renewed focus by investors during this period of uncertainty and market volatility.

The capital gap has returned

The banking sector is under pressure on several fronts. As a result, banks are still lending but are being selective and offering lower amounts of leverage. When banks tighten lending and offer lower loan-to-value (LTV) loans, borrowers will turn to other sources of capital, such as debt funds, and/or subordinate debt capital sources to fill the capital gap.

As observed during prior periods of stress, it appears the capital gap has once again emerged as an opportunity for debt funds to invest in assets banks would’ve generally executed on. Reset values lead to better entry points and lower exposure levels As interest rates have increased, the higher debt costs have put pressure on.

Reset values lead to better entry points and lower exposure levels

As interest rates have increased, the higher debt costs have put pressure on property valuations. This adjustment to a new rate environment will take some time to settle and the ultimate range of the 10- year Treasury will be a significant driver of these valuation adjustments. The classic bid ask stalemate will likely exist for nonforced sales until investors feel valuations have reset to a reasonable level. Still, the longer this volatility continues, the more the pressure begins to build. There has been some acquiescence in the market where sellers are beginning to accept new values.

Whether the post inflation valuation decline is 5% or 20%, new debt investment/loans will be sized to reset values generating a fresh equity buffer and lower exposure levels.

Private real estate credit remains a solid complement and hedge to core equity holdings

As highlighted, property values are in the process of adjusting to higher debt costs. Even the preferred property types are not immune to this dynamic. An allocation to credit with a current income focus is a logical complement to core equity where investors can achieve a higher return than recently observed in the debt arena while maintaining a more protective position in the capital stack.

Private real estate credit in the world of elevated inflation

A. Short duration
The majority of loans in the space are structured as floating rate debt. The accompanying low duration profile has been a positive for investors as interest rates have risen, resulting in losses in many fixed income portfolios in 2022 and into 2023. As the market anticipates short-term rates to stay above 2.5%, short-term yields will likely have a fairly solid floor at or near the Fed’s inflation targets and the Fed will be reluctant to cut rates too far.

B. Real assets
Historically, commercial real estate has had a positive correlation with inflation. When inflation occurs, the resulting higher construction costs should slow the new supply benefiting existing properties. Interestingly, inflation is indirectly slowing supply by increasing debt costs and making it difficult to project returns on new developments.

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