During the third quarter of 2022, banks began scaling back on their commercial real estate lending. This followed several years of almost manic underwriting at extraordinarily low interest rates.
There were a few reasons why banks did an about-face on funding CRE projects and continue to do so. One justification was an increase in the prime rate, spurred by the Federal Reserve’s rapid boost of the Effective Federal Funds Rate. The threat of regulatory oversight and choosing to reduce their exposure to the commercial real estate sector are other compounding factors.
It goes without saying that traditional lenders’ capital pullback creates challenges for commercial real estate developers, owners and investors. Without liquidity, buildings don’t get built and investors don’t buy them.
But rather than throw up their collective hands in exasperation, CRE borrowers are busy seeking other capital sources. Borrowers are coming up with more equity and relying on private debt funds for mortgage loans.
By extension, the greater demand for private debt fund loans is creating a compelling investment opportunity for investors. Private debt funds had a banner year of both lending and fund-raising in 2022. This state of affairs will remain the same through the rest of 2023 and well into 2024.
Finding Funds
From a borrower standpoint, private debt funds have provided ideal alternative capital in the face of traditional lenders’ restrictions. Private debt funds aren’t bound by the loan-to-deposit ratios required by banks and credit unions. This is because private debt funds raise capital from investors, rather than having to depend on depositors.
Additionally, private debt funds are free from the myriad regulations that traditional lenders are required to follow (including the above-mentioned loan-to-deposit requirements). It should come as no surprise that banking is one of the most highly regulated institutions in the United States.
Alternatively, private debt funds have a high degree of flexibility when it comes to loans. Originators can more easily customize debt offerings for specific projects. They can adjust loan terms and interest rates based on the development or investment, rather than on legislative mandates or indexed interest rates.
The continued demand for liquidity, combined with the banking pullback, has generated more opportunities for private debt funds to become the funding source of choice. This, in turn, has positioned private debt funds as enticing investment vehicles.
The Investor Component
From an investor standpoint, private debt funds can fit various investment strategies due to the following:
Greater yield. The returns on private debt funds tend to be higher than traditional fixed-rate equity assets or listed bonds. This is because fund returns are determined by interest rates , which are normally floating rates and in the current environment, produce a higher return.
Diversification. Private debt funds are not correlated to the public equity and bond markets. In other words, the valuation of private debt funds differ from that of stocks, bonds and more traditional investments. Because of this, private debt funds can be ideal for portfolio balancing and diversification strategies.
Inflation hedge. Private debt fund loans typically carry floating interest rates. Floating rates can offer more protection from inflation than their fixed-rate counterparts. According to a McKinsey report, investors have been seeking out private debt funds for this reason and others: Yield (as mentioned above) and a senior position in the capital stack.
Investor safety. The majority of private debt fund managers have their own skin in the game. In other words, they are putting their own capital into the fund, along with the investors. And unlike traditional lenders, private debt funds keep loans on their balance sheets, rather than packaging them and re-selling them as commercial mortgage-backed securities (CMBS). This provides a greater level of security for investors.
Higher Demand, More Opportunities
There is no indication that banks and credit unions will suddenly open their coffers and start providing more capital for commercial real estate projects. In fact, given the recent bank failures, many traditional lenders are circling the wagons to keep more cash on their balance sheets. This means more CRE borrowers will turn to private debt funds to close deals and spur development. These funds, in turn, will need a great deal of capital – from investors.
Given the returns, hedge advantages and security linked to private debt funds—combined with increasing demand from borrowers—private debt funds can offer a compelling and strategic choice for investors.