Commercial Real Estate’s Private Credit Market Is Just Revving Up

Success is not about breaking down walls; it’s about finding the door.

With commercial real estate owners facing a wall of maturities in the trillions of dollars, there is a door for private credit lenders to earn equity-like returns at a favorable position in the capital structure.

Private credit is already seeing outperformance: the State Street PE Index had private credit funds beating private equity funds, their merger and acquisition-focused rivals, by more than five times in the third quarter of 2023, the last quarter for which there is data.

The current market sets a promising stage for private credit investors.

I expect banks to actively decrease their commercial real estate exposure, resulting in a scarcity of debt capital, which is unlikely to change meaningfully for the next few years. Considering the current state of bank lending in the commercial real estate market, it is unlikely that the usual suspects — insurance companies, government agencies or CMBS — will be able to fill the gap, which opens the door further for private credit.

Citigroup found that regional or smaller lenders hold roughly 70 percent of commercial real estate loans. With almost $1 trillion of these loans maturing this year, a function of mass extensions from 2023 maturities, it is unlikely that these smaller financial institutions will have the ability or interest to extend these loans, keeping the door open longer for private credit lenders.

We are already seeing this play out with banks, as they have had the most significant pullback in originations, down 50 percent annually in dollar volume in the fourth quarter of 2023.

From an investor downside protection standpoint, today’s commercial real estate loans are generally characterized by lower loan-to-value ratios (LTVs), better coverage ratios, and more favorable covenants and structures despite higher rates.

Commercial real estate experienced a year of transition last year. The dramatic rise in interest rates triggered a significant repricing of commercial real estate properties and suppressed transaction activity. Sellers were unwilling to transact at lower values, and interest rate volatility made it difficult for buyers to determine the correct entry point. However, the main challenge was the lack of available credit.

Looking ahead, our view is that interest rates have normalized, with the industry accepting that interest rates will be “higher for longer.” However, borrowers who financed cheaply a few years ago will soon hit a maturity wall. Many will struggle to refinance at higher costs. Some will default. Private credit will step in and bridge some of the financing gap left by the banks.

After last year’s regional bank failures and property value declines, banks’ liquidity and commercial real estate portfolios are under heavy scrutiny.

Financial institutions, particularly banks, which account for most of the commercial real estate loan activity, are selling loans to cope with U.S. oversight proposals and their balance sheet challenges, creating another significant opportunity in the private credit market to generate outsized returns.

Commercial real estate credit offers attractive valuations compared to other asset classes, considering the sector’s significant repricing. This current market environment presents a promising opportunity for investors to earn appealing risk-adjusted returns by lending to high-quality, well-located assets affected by the overall reset in property values and liquidity decline.

Many property owners face difficult choices, given declines in value and the need to refinance, and a growing number are likely to come under pressure to sell properties. Those firms with a debt and equity platform are better positioned to navigate these challenges and execute this trade effectively. Sales transactions should open up further as we move into 2025, with the potential for an acquisition boom.

By adopting a strategic and disciplined approach, investors can be positioned for long-term success by having opportunities presented to them during the market’s ups and downs.

Greg Friedman is CEO of Peachtree Group, a real estate investment firm.