Four things to know about real estate private credit within the expanding universe of private credit
Originally published on LinkedIn in Jan Brzeski’s Observations newsletter. Republished here with permission.
As I mentioned in my first article, I find real estate private credit to be compelling both as an asset class and a career. In the last few years, the media has deemed this to be the golden age of private credit overall, with headlines such as “The new kings of Wall Street aren’t banks. Private funds fuel corporate America,” from The Wall Street Journal.
According to McKinsey, the private credit asset class has been one of the fastest-growing segments over the past 15 years, growing 10x since 2009 to roughly $2 trillion today.
Real estate private credit (REPC) is one subset of the massive overall nonbank private credit (PC) market. This contrasts with the traditional bank lending markets or the public debt markets, which include government, municipal and corporate bonds.
Private credit soared after bank lenders retrenched after the Great Financial Crisis (GFC) of 2007-09, prompting regulators to increase capital and other requirements around bank lending. The most well-known sector of private credit is known as direct lending, where private, nonbank lenders negotiate loan terms directly with corporate borrowers. Real estate private credit (REPC) means investing in loans that are secured by real property — such as homes, apartment buildings and commercial properties. Other private credit sectors include specialties such as aviation finance, music royalties and inventory finance. Firms such as Ares, Blackstone, Goldman Sachs and Apollo have all built substantial private credit businesses, including direct lending and other sectors including REPC.
Below are four things to know about real estate private credit as compared to direct lending to companies.
Both industries are growing for similar reasons. The GFC marked a turning point where bank regulation became much stricter, resulting in a pullback of bank lending to both companies and real estate investors and developers. Since then, specialized managers have emerged in both sectors and have become some of the most active lenders in their respective markets. Capital flows to these specialized managers have enabled both sectors to grow dramatically since the GFC.
Both industries are very diverse beneath the surface. Real estate private credit could be a $200,000 loan on a home being renovated for resale, or a $200 million loan on a hotel or office building. Loans can be senior liens or junior liens. And locations could span the spectrum from the largest metro areas to tertiary markets. On the corporate side, the borrowing company could be a private equity-backed company with many billions of dollars in sales, down to a small local business. Different lenders specialize in a wide range of submarkets, in both real estate and corporate direct lending.
Real estate loans are secured by real property — but that doesn’t automatically make them safer. When it comes to lending, the details make all the difference. Loans secured by real estate are appealing in that you can see the property and assess its value, and compare the loan or loans on the property to the value, to establish the extent of the margin of safety. But a real estate loan may be risky, for example, if the leverage is too high or the property type is too volatile (such as vacant land). Likewise, an unsecured loan to a company may be safe if the company is very stable, the loan is the senior-most part of the capital stack, and the cash flow of the business is many times higher than the debt service.
Both REPC and PC are neither good nor bad, but they are very big. In order to generate strong returns, investors of all kinds tend to use significant leverage, or borrowing, as part of the capitalization of their investments. As an example, the amount of debt is typically more than half of the capital for real estate projects — usually between 60% and 75% of the total project cost. This means that debt is a larger asset class than equity. With banks no longer providing debt for as many transactions — including real estate projects or buyouts of private companies — the addressable market opportunity for PC is enormous, up to $30 trillion, according to McKinsey.
Summary
What was once considered the boring part of the capital structure — investing in loans as opposed to actually purchasing real estate or companies — is now driving revenues, profits and growth plans at the world’s largest alternative investment managers, and also at thousands of smaller specialized direct lenders in every niche imaginable.
