Success isn't about breaking down walls, it's about finding doors.
With commercial real estate owners facing trillions of dollars in payment dues, the door is open for private credit lenders to gain an advantageous position in the capital structure and earn equity-like returns.
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Private credit is already outperforming: Private credit funds outperformed rival private equity funds that focus on mergers and acquisitions by more than five times in the third quarter of 2023, the last quarter for which data is available, according to the State Street PE Index.
The current market conditions are favorable for private credit investors.
We expect banks to aggressively reduce their commercial real estate exposure, resulting in a debt capital shortage that is unlikely to change significantly over the next few years. Given the current state of bank lending in the commercial real estate market, it is unlikely that the usual suspects — insurance companies, government agencies, and CMBS — will be able to fill the gap, further opening the door to private lending.
Citigroup found that regional or smaller financial institutions hold roughly 70% of commercial real estate loans. With roughly $1 trillion of these loans maturing this year and a slew of expected extensions from maturities in 2023, it's unlikely that these smaller institutions will have the ability or interest to extend these loans, keeping the door open for private credit lenders longer.
This phenomenon is already evident in banks, which have seen the steepest declines in lending, with loan volumes down 50 percent in the fourth quarter of 2023 compared to the previous year.
From an investor downside risk protection perspective, today's commercial real estate loans are typically characterized by lower loan-to-value ratios (LTV), higher coverage ratios and higher interest rates, yet more favorable covenants and structures.
Commercial real estate was in a state of flux last year. A sharp rise in interest rates caused a major repricing of commercial property and dampened deal activity. Sellers were reluctant to transact at low prices, and fluctuating interest rates made it difficult for buyers to gauge when the right time was to enter the market. But the main challenge was the lack of available credit.
Looking forward, we believe interest rates will normalize and the industry will accept that rates will be “higher for longer.” However, borrowers who got cheap loans a few years ago will soon hit a maturity wall. Many borrowers will struggle to refinance at higher costs. Some will default. Private credit will step in and fill some of the funding gap left by the banks.
Banks' liquidity and commercial real estate portfolios have come under intense scrutiny following last year's failures of regional banks and falling real estate values.
Financial institutions, especially banks that account for a large proportion of commercial real estate lending activity, are selling loans to address U.S. oversight proposals and balance sheet challenges, creating another big opportunity to make big profits in the private credit markets.
Commercial real estate credit offers attractive valuations relative to other asset classes given the significant repricing in the sector. The current market environment offers a promising opportunity for investors to earn attractive risk-adjusted returns by financing high-quality, well-located assets that are subject to a general reset in real estate values and reduced liquidity.
Many real estate owners are facing difficult choices due to declining values and the need to refinance, and more will likely feel pressured to sell their properties. Companies with debt and equity platforms are well positioned to navigate these challenges and execute these transactions effectively. As we move into 2025, we may see more sale transactions and a boom in acquisitions.
Adopting a strategic and disciplined approach can position investors to capitalize on opportunities during market ups and downs and position them for long-term success.
Greg Friedman is CEO of real estate investment firm Peachtree Group.