As featured in WMRE 2023 Market Outlook
As economic uncertainty and rapidly rising interest rates drive investor apathy and traditional lenders further rein in their activity, private credit continues to be an increasingly attractive frontier. In fact, McKinsey research found that direct lending accounts for 73 percent of the overall growth in private debt fundraising over the past decade.
Yet rather than being worried about competition, savvy investment managers recognize that inefficiencies within the private credit sector are abundant—specifically as it relates to senior mortgages for middle-market commercial real estate (CRE).
New CRE mortgage originations have averaged $530 billion per year since 2015, bringing the level of outstanding commercial and multifamily debt to a record $4.4 trillion by midyear 2022, according to the Mortgage Bankers Association.
While banks, agencies, CMBS and life insurance companies account for over 85 percent of the real estate debt space, private lenders are gaining market share, with more than $520 billion in outstanding mortgages. Assuming a quarter of those loans roll over each year, it represents a $100-billion-plus opportunity for alternative lenders.
Several larger, institutional-type private players have also raised billions for private debt funds recently. These vehicles—whose investment thresholds are often high and prohibitive for smaller investors—account for 27 percent of the $108 billion raised for CRE during the first nine months of 2022. Due to the scale of capital deployment required, these funds typically compete within the same shallow pool of class-A properties in top-tier markets.
That leaves a huge gap in capital availability for a large segment of CRE: the small- to middle-market. Thanks to increased regulations, traditional lenders now account for just 11 percent of sponsored middle-market financings, down from nearly 70 percent in 2013. This is the sweet spot for private credit providers and investors who can take advantage of market dislocation.
CRE debt funds in general go a long way in diversifying broader investment portfolios; their scale alleviates single-asset risk exposure by distributing capital across a pool of loans and they have more accretive return profiles compared to broader fixed-income asset classes.
Private credit also has a low correlation with the equity markets and is structured to achieve a fixed rate of return, predictable cash flows and a yield premium relative to fixed-income alternatives. Investors with varying appetites for risk can move up and down the capital stack; returns typically range between 5 percent and 8 percent at the lower-risk end of the spectrum and can reach low- to mid-teens, depending on deal structure.
As small- to middle-market CRE debt investment grows and matures, there will be ample opportunities for individual investors to achieve consistent, stable yield. For those looking to invest in the space, it’s crucial to choose the right manager with which to place your capital.
The strongest direct lenders in the market will have a team with comprehensive industry knowledge and connections, access to discretionary capital and a fully integrated real estate platform to oversee the life of their loans. Furthermore, managers with cohesive debt and equity capabilities will have a broader relationship base, a better understanding of pricing inefficiencies and consistent borrower demand from which to cherry-pick opportunities.
When aligned with the right investment manager, real estate private credit marries the attractive features of both debt and equity: stable, downside protection with consistent cash flow on the credit side, backed by equitylike returns and a direct inflation hedge tied to real estate ownership. The dearth of capital providers focused on the middle-market space provides a meaningful opportunity for investors and asset managers looking to capture market inefficiencies in scale.