Why it’s (still) a good time to invest in private real estate credit

11/25/2024

Author

Kirloes Gerges

Kirloes Gerges

Managing Director, Portfolio Management, Principal Real Estate Private Debt

Principal Asset Management

Blogarticle

Why it’s (still) a good time to invest in private real estate credit

At the start of 2023, we identified a series of advantages to investing in private real estate credit; the capital gap, better entry points at lower post-inflation valuations and attractive relative value. They are still valid, in part because the tailwinds that drove opportunities in the real estate private credit market in 2022 are still driving opportunities today.

Given the tailwinds and resulting opportunities, it’s no surprise that private real estate credit funds continue to see steady growth in assets under management.

The capital gap persists
Since early 2023, the capital gap that had emerged from a banking sector under pressure and a large wall of coming maturities has not changed for the better.

The banking sector is under pressure on several fronts including bank management teams being concerned about how their books will perform going into the Fed induced economic slowdown. Bank balance sheets are heavy from a flurry of activity in 2021. Banks are also under close scrutiny from regulators and face capital adequacy pressure from stress testing and other factors.

There will be existing loans coming due that need to be paid off and the borrowers will be required to refinance/ recapitalize these assets.

Supply continues to wane
Since 2022, traditional lenders have remained muted. Persistent inflation, continued uncertainty about the economic impact of Fed tightening, and failures including Silicon Valley Bank and First Republic Bank, contributed to a 47% decline in commercial lending activity in 2023 over 2022. Banks led the pullback, with a 64% decline.

Bank lending is likely to remain muted for the foreseeable future, as the drivers of the conservative mindset persist— including the Fed’s fight against inflation and a lack of visibility on the contour of the slowdown that may result.

Demand continues to grow

The ‘wall of maturities’ continues to grow. There are now approximately $2trillion in loans maturing over the next 3 years. Borrowers will be required to refinance/recapitalize these assets— driving huge demand for capital in an environment marked by waning supply.

The result: Wider spreads and total yields
Diminishing supply and increasing demand has created a lender’s market, with favorable conditions including rising spreads and total yields.

Looking forward, there’s no indication of aggressive rate cuts coming to fruition or spreads tightening significantly. Relatively high rates allow for outsize yields.

Higher cap rates, lower valuations, more opportunity
The Fed’s series of interest rate hikes and a persistent high interest rate environment have driven capitalization rates higher, in turn, driving valuations down. And created opportunities for new investments sized to reset values— generating a fresh equity buffer, lower exposure levels, and higher returns.

Higher cap rates drive collateral valuation drift
For existing loans, higher cap rates means higher LTV ratios— and collateral valuation drift. Appraisal valuations are still in the process of catching up with market declines, so portfolio valuation metrics on legacy collateral may appear to be better now than where they may ultimately land in another 2 to 3 quarters.

Allocations to real estate credit strategies should be made in vehicles targeting new investments. Higher cap rates also drive attractive returns on reset values Allocations should also be made in vehicles targeting new investments as new investments will be sized to reset values—which should generate a fresh equity buffer, lower exposure levels, and higher return potential.

Historically, the best risk-adjusted credit investments have been made coming out of periods of market turmoil. The next few years are setting up to be the start of a new credit cycle and the role of private lenders is expected to continue expanding. We believe it is still a good time to invest in private credit.

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