Private credit isn’t new, though it may seem that way. It has actually been around for hundreds of years, and when you think beyond the regulated environment we know today, it has existed for centuries. In today’s modern era across the commercial real estate world, private credit is largely synonymous with debt funds.

Gabriel Silverstein, SIOR, managing director of SVN | Angelic Commercial Real Estate Advisors in Austin, Texas, says, “The debt fund model really broke out and became a market force after the GFC, since about 2008. It has been a market player for a limited time, over the last 10 to 12 years, compared to CMBS which has been tapped as a CRE capital source for more than 30 years, and REITs which became prominent in the early 1990s. Debt funds are the youngster capital source that will continue to evolve and become very mainstream now both for borrowers and investors who need a place for risk adjusted returns.”

Quasi-institutional lenders have big pools of available capital that sits outside of much of the regulatory scrutiny that banks, credit unions, pension funds, or insurance companies face in their direct lending practices. In a lot of cases, debt funds and the investors in those debt funds, ironically, are some of the same lenders — especially on the insurance side — that are much more highly regulated when they act as direct lenders. But these entities can invest in a large REIT or investment fund outside of their direct real estate lending practices, and it's not regulated the same way.

Mark Goode, SIOR, a co-founder and principal of VentureOne Real Estate, a Rosemont, Ill.-based firm that focuses on industrial properties, defines private credit in two different ways. First is debt where private equity finances deals from a debt perspective. Then there's private capital that will buy real estate as equity and get other debt either from banks or insurance companies or other sources.

“There's always been private debt. It wasn’t invented today. Our company raises private equity from high-net-worth individuals for our funds. That's quite different than raising money to provide debt. Recently, notes Goode, “Banks have been flush with capital going into real estate. They might have had 80% of the debt going out, and private capital might have had 20%, because private capital was more expensive.” Now, he says, the market might be 60% bank and 40% private. “The reason private equity works today more than just a bank loan is that the assets that they might be loaning on are being underwritten at a value significantly less than they were two years ago or three years ago,” he adds. That provides a bigger cushion to pay a little bit higher interest rate or have different terms of private equity and also participation on the back end or in cash flow or in income. The private capital market is typically a little bit more flexible. So that could involve a joint venture piece of debt, convertible debt, or some form of equity. “There's a lot of different ways to structure private equity where banks don't have that same option,” Goode says.

RELATIONSHIP TRANSACTING

Relationship building is what Goode’s firm focuses on, especially with lenders today. “Our relationship with our lenders is as important as our relationship with our brokers,” explains Goode. “It helps create long term capital sources that treat borrowers fairly with an honest opinion quickly if they want to do a deal. That way time isn’t wasted.” Building a debt program around that type of relationship allows for adjustments to current conditions with a clearer understanding of where rents, rising interest rates, and increased construction costs are heading.

“When times are good, we wanted to be fair to our lenders because we know times aren't always good,” he continues. “So now, lenders have backed off of office and retail and slowed down on industrial and other areas. Because of the relationships built with them in good times, they're still there for us now.” Goode also advises it is important to match a loan request to the lenders criteria to make it comfortable for them and not push their limits. “Finding the sweet spot of what they want to do is important,” he says.

 

INSTITUTIONAL PRIVATE CREDIT STRATEGIES

For larger institutional investors, private capital strategies make sense when looking to invest with a large insurance company or pension fund via private funds, rather than in direct investment vehicles. The regulations are different for direct investments versus fund investments, which has led to a strong capital flow to private funds.

This investor category needs to drive large-scale returns and make larger investments, typically involving $100-million-plus projects. That is a significantly higher commitment level, but it also translates into a lower number of investments. Larger scale investors are not set up organizationally to handle a high volume of deals from a staffing and infrastructure perspective. In order for them to achieve their investment return objectives, they must do so efficiently and by deploying their capital through a number of investment partners.

This arrangement involves institutional investor entities that manage the managers. They select and manage relationships with sponsors, whether that be a lender, direct investor or manager. They oversee the people they partner with as opposed to overseeing the investments directly or indirectly managing their investments.

Larger-sized investors such as MetLife or New York Life typically don't make direct loans under $20 to 25 million and generally prefer $50 million and above, says Silverstein. The staffing required to process each deal is relatively the same, which means it takes the same amount of time and effort to do a $5 million loan as it does a $50 million loan. Yet, institutional investors only receive a tenth of the bang for their buck investment-wise. To get the same number of dollars out the door requires ten times as many people and a larger internal set up. They can’t achieve the volume needed via smaller deals that they can if they partner with private sponsor investors by providing investment capital in the $100 million or $400 million range.

“Institutional investors in regulated environments understand real estate is one of the best investments they can have,” says Silverstein. “Bonds and real estate are very predictable, and historically over most periods of time, deliver reasonably consistent cash flows, which is attractive especially if you're a lender or buying bonds. They are very active in commercial real estate and have been forever, and part of the reason they are investors in debt and equity funds is because they can invest through those private entities that are outside of stricter regulations than if they invested or lent money directly into some of the same real estate transactions.”

But as an alternative to banks or insurance companies, large funds like Blackstone decided to set up a debt vehicle for developers or investors, as opposed to a bank or an insurance company, which had been hit hard, especially on the CRE loans for office and retail buildings. The larger funds that were set up served to provide an alternative investment vehicle in the form of debt to developers or requires a real estate option like what Goode’s firm does, which didn't exist before.

Private capital tends to focus on and invest in debt funds set up by groups such as PCCP, Oaktree, or Blackstone, because these unregulated investments via bridge lenders offer higher returns as they move up the risk scale. Traditional bank lenders are not able to lend on those deals because they are just too risky in their regulated environment. For institutional type of investors, like insurance companies, a 12% to 13% or even 9% to 10% deal may be considered a reasonably lower risk investment that works for them given the return for their risk spectrum.

Groups that are professionally managed and institutionally sized with funds in the $20- to $40-million range are attractive to investors seeking risk adjusted returns in the private space. But they can also be funds exceeding $400 million or someone like Prime Group that assembled a nearly $2 billion fund. That allows this private investment capital to flow to a larger and often diversified portfolio of assets. From a risk point of view, they might be investing in higher risk deals because the assets are transitional, but for the right sponsor with the right leverage point, it can translate into a much higher return, which is why they invest in these debt funds as private credit, notes Silverstein.

MARKET CHALLENGES

The reason private credit is proliferating today is because markets are challenged right now, and markets that are in turmoil are difficult for regulated entities to participate in because turmoil itself creates more risk. Turmoil is coming from higher interest rates, an uncertain economy, rising inflation, bank failures last spring and a host of other factors. Regulators are increasing reserve requirements for banks, and construction loans are facing harsh judgement under the newer evaluations. Ultimately, that impacts the real actual interest rate when reserve requirements are factored in — thus income margins are squeezed even tighter for banks. That has driven down new loan origination the past six months as banks hoard cash to ensure they have sufficient cash reserves as new reserve requirements are established.

“When that happens, the market says, ‘Where'd my lenders go?’ And that's when private capital steps in and says, ‘I see a dislocation in the market,’” notes Silverstein. Goode’s number one criteria is flexibility. “We don't want to be in a situation where we have to have a long-term loan or a loan that can't be paid off without with big penalties,” he says. “We're opportunistic buyers and opportunistic sellers. So, any debt that we put on a property has to have a way out.”

There are two things transpiring in the overall market at the same time. One is a market that's experiencing some turmoil. Prices have been going down and that's a challenge, even though that's leveling off. At the same time, costs are continuing to increase. Simultaneously, there is an extra non-real estate factor to consider via the Federal Reserve. “The Fed just introduced a new variable and changed or is changing reserve requirements and the scrutiny they're putting on those loans,” notes Silverstein. “Therefore, that externality just compounded the market dislocation and because of that the door just opens even wider for private capital.”

When the market faces challenges, larger companies tend to be less entrepreneurial and adopt less risky strategies. Big, regulated companies sit out and that provides an opportunity for private investors to seize opportunities. Their approach can still be very discriminating, though very aggressive since regulators aren’t looking over their shoulders.

The appeal of the private debt fund for investors is simply finding a risk adjusted return. Large institutional type of investors may be missing out on exposure to entire segments of the market without the private fund option. Private credit is not viewed as a serious rival to mainstream lending but more as a complementary option. Finding the right tool makes sense rather than only considering one type of capital source.

REDEFINING THE CATEGORY

Understanding the conditions that attracted private credit to fill a void from the banks is a simple evaluation. Banks pulled back as interest rates rose. Should that change, banks would likely return to the lending market when the can make the returns they seek on debt. That would bring the balance between banks and private credit back to an 80/20 split.

Silverstein notes, “We were doing loans with people at significantly lower, cheaper money then the hard money world. This whole avenue opened up because banks couldn't make any loans.” Private capital is firmly established as a viable source of capital now and has redefined the category. These private investment strategies are no longer viewed as hard or difficult money for borrowers. “I think you've removed a big part of the word hard from the acumen of the industry, which is to say, in challenging times there are a lot of lenders now that can lend on challenged transitional assets,” says Silverstein.

The result is borrowers can and are tapping into a real, viable market with a whole market of lenders that can provide access to fairly priced capital given the risk profile of a deal. Indirectly, the impact on the market is more borrowers are willing to take the plunge on transitional assets. It makes the market more liquid because they can borrow more, more readily, which gives liquidity to them as a borrower. The entire market now has more liquidity because there are more buyers able to go in and go after struggling assets to take them on and try to fix them.

In some cases, that can translate to going up to a higher LTV than traditional hard money lenders did. Pricing can be better and because the product is from an institutional lender, there is more confidence for the borrower that it is working with a lender whose business is making loans with the true intention of getting paid back, rather than making a loan with the goal of taking over as the owner of the property eventually if the borrower faces issues, notes Silverstein. A significant difference from the borrowers’ viewpoint is that most of these loans now are non-recourse deals. Sophisticated borrowers who are educated, understand it can be another built-in protection for them. Silverstein says, “That is a very big deal, we think, to borrowers, especially on transitional properties. If things turn sour, they may still lose their equity, but they won’t lose their house or other assets.”

“In the debt fund world, I think we've only just barely gotten to a point where maybe we're going to start to see kind of Debt Funds 2.0. It is going to be interesting and fun to see what unfolds in the next generation,” Silverstein continues. “It's only going to further benefit borrowers, and buyers of real estate, and if it benefits borrowers and buyers, it's going to benefit the whole market, including sellers."

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CONTRIBUTING MEMBERS

• Mark Goode, SIOR 
• Gabriel Silverstein, SIOR