Attractive opportunities for diversification with private real estate credit

September 23, 2024 | 4 min read

Kirloes Gerges

Managing Director, Portfolio Management, Principal Real Estate Debt

Troy Kort, CFA

Portfolio Manager, Principal Real Estate Investors

Historically, the best performing investment vintages have often followed periods of distress and volatility. Commercial real estate has experienced a significant downturn since the Federal Reserve (Fed) started raising interest rates in the spring of 2022. However, in our view, the stage is now set for real estate credit to generate attractive income returns with favorable risk tailwinds.

At-a-glance

We believe the environment is favorable for real estate credit to generate attractive income returns with supportive risk tailwinds. Here we explain three reasons why:

Banks’ pullback on direct real estate lending creates opportunities for private lenders.
Real estate credit is well-positioned to navigate an economic slowdown.
Opportunities lie in newly assembled portfolios; legacy vehicles are burdened with risks driven by valuation declines in underlying collateral.

Introduction: Downturn leads to opportunity

Over the past three years, performance in the commercial real estate (CRE) sector has been quite different than in other sectors. The NPI Appreciation Index, which tracks the performance of commercial real estate, peaked in the second quarter of 2022 and has fallen roughly 19% through the second quarter of 2024. (CRE performance may have been even worse than that since the NPI is an appraisal-based index and data can lag. Real time trades indicated declines may be 30% +/- from the peak to date.)

In contrast, the S&P 500 is trading at near record highs—up approximately 53% as of 30 June 2024, from the third quarter of 2022, fueled in large part by technology companies. Even after a week of turmoil in early August, fixed income spreads are re-approaching decade lows—indicating a high degree of investor confidence in the Fed engineering a soft landing.

EXHIBIT 1: Equities and fixed income have had a significant run-up in valuation, while CRE is bottoming

Line chart showing how Equities and fixed income have had a significant run-up in valuation, while CRE is bottoming

Source (left): Ice Data Indices, LLC, St. Louis Federal Reserve, 30 June 2024.

Source (right): NCREIF, S&P, Principal Real Estate, 30 June 2024. Indices are unmanaged and do not take into account fees, expenses, and transaction costs and it is not possible to invest in an index.

The downturn in commercial real estate began after the start of the Fed’s interest rate hikes in the spring of 2022. Now, the relatively poor performance of the commercial real estate sector has set the stage for potentially attractive investment opportunities. We believe real estate credit (private debt investments collateralized by commercial real estate assets such as multifamily properties and warehouse buildings) is now well-poised to generate attractive income returns with favorable risk tailwinds. Here we explain three reasons why.

Banks’ pullback on direct real estate lending creates opportunities for private lenders

Banks are regularly in the news reporting losses from their commercial real estate loans. These are, of course, legacy portfolios, and banks are likely going to report losses on their CRE loans for several years to come. The process of working out problem loans, especially office exposures, takes time. Loans will be restructured or foreclosed, and in some cases, both. Eventually, banks will realize the losses, and values and market rents will clear.

While banks work through this stress, they have dramatically pulled back on direct real estate lending. At the same time, banks are also looking to finance senior mortgages as regulators provide better capital treatment for this conservative risk profile. The stage is set for private lenders to increase market share, similar to the gains made post the global financial crisis.

EXHIBIT 2: Banks continue to pull back on direct real estate lending

Pie chart showing how banks continue to pull back on direct real estate lending with market share by participant.

Source: As of 31 December 2023. Source: Mortgage Bankers Association. 4Q 2023. GSE – Government-Sponsored Enterprise.

Real estate credit is well-positioned to navigate any future economic slowdown

A recent industry survey indicated market participants believe average appreciation for apartments and industrial properties will be in the low single digits for the 2024-2028 period. In contrast to equity investments, real estate credit returns primarily consist of loan payments and thus are almost all in the form of income. So, while future value appreciation may be muted, the income focus of real estate credit may help support achieving the targeted returns.

Given the debt profile, real estate credit investors receive the greater protection afforded by being senior to the equity investor in the capital stack—often roughly 25-30% of an asset’s capitalization. On the heels of the recent 20- 30% drop in collateral values, coupled with a fresh 25-30% new equity cushion, we believe real estate credit is wellpositioned to navigate an economic slowdown—even a recession.

EXHIBIT 3: Potential GDP growth scenarios

Line chart starting in 2022 projecting into 2027 for the Potential GDP growth scenarios by billions for assets under management.

Source: Bureau of Economic Analysis, Moody’s Analytics, Principal Real Estate, 30 June 2024.

Legacy vehicles pose challenges; opportunities lie in newly assembled portfolios

On the surface, it may not seem intuitive to allocate capital to a space in which valuations have been under pressure. For legacy real estate credit vehicles, that is true. The valuation of legacy loans can be difficult, making it hard to ensure the accuracy of the net asset values. Furthermore, dealing with liquidity needs in an environment in which the loans are under stress can be quite challenging.

Those challenges are not present in a newly formed investment vehicle comprised of post-inflation loans. More recently assembled portfolios factor in real-time valuations based on today’s higher interest rate environment. Therefore, they enable investors to take advantage of the position of the CRE sector now and the opportunities to come.

Summary: Strong opportunities for diversification with real estate credit

For future asset allocation decisions, there is a strong argument to take some “chips off the table” with respect to U.S. equities and to diversify a portfolio’s debt holdings. The opportunities presented by commercial real estate credit are driven by the distress caused by rate hikes in both the banking sector and broadly across the real estate market. This is not a new phenomenon; real estate credit has historically performed best in the years following a downturn. We believe reset valuations, the strength of current market loan-level metrics, and the quality of the underwriting practices, make for attractive opportunities in real estate credit.

Real estate

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For Public Distribution in the United States. For Institutional, Professional, Qualified, and/or Wholesale Investor Use Only in other Permitted Jurisdictions as defined by local laws and regulations.

Risk Considerations
Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. Asset allocation and diversification do not ensure a profit or protect against a loss. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate. Private credit involves an investment in non-publicly traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control.

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In Europe and United Kingdom, this website is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID and FCA respectively). If you are viewing the material as a retail investor, you should seek independent investment advice before deciding whether the products and services in question are suitable to meet your investment needs and objectives, as the language has not been complied to a retail client standard.

Principal Global Investors Funds
Principal Global Investors (Ireland) Limited is the issuer of the Funds. Investments may only be made on an application form attached to a current prospectus and following receipt by the investor of the KIID in respect of the Fund in which they intend to invest. The latest version of the prospectus of the Funds is dated 14 December 2012.

For Real estate investors in the European Economic Area (“EEA”), this website and the information on it is only directed at persons who are professional investors for the purposes of the Alternative Investment Fund Managers Directive (2011/61/EU) (“AIFMD”), professional clients or eligible counterparties for the purposes of the Markets in Financial Instruments Directive (Directive 2014/65/EU) (“MiFID II”) or as otherwise defined under applicable local law and regulation and at whom this website and the information on it may lawfully be directed in any relevant jurisdiction (“Eligible Persons”). In relation to each member state of the EEA (“Member State”) which has implemented AIFMD (and for which transitional arrangements are not/ no longer available), this website may only be accessed and interests in Funds may only be offered or placed in a Member State to the extent that: (i) the relevant Fund is permitted to be marketed to professional investors in the relevant Member State in accordance with AIFMD (as implemented into the local law/regulation of the relevant Member State); or (ii) this website and its information may otherwise be lawfully distributed and the interests in Funds may otherwise be lawfully offered or placed in that Member State (including at the initiative of the investor). In relation to each Member State of the EEA which, at the date of accessing this website, has not implemented AIFMD, this information may only be distributed and interests in Funds may only be offered or placed to the extent that this information may be lawfully distributed and the interests in Funds may lawfully be offered or placed in that Member State (including at the initiative of the investor).

Persons who are not Eligible Persons, including but not limited to those individuals or other persons who fall within the FCA’s definition of ‘retail clients’, should not use or rely upon this website or the information contained therein and may not engage the services of Principal Real Estate or any of its affiliates, or invest in any Fund. Potential investors are advised that all or most of the protections provided by the UK regulatory system will not apply and that the UK Financial Services Compensation Scheme may not be available in relation to an investment in a Fund or separate account.

The contents of this website have not been verified or approved by any competent regulatory or supervisory authority. No liability, whether in negligence or otherwise, arising directly or indirectly from the use of the information or any part of it on this website is accepted and no representation, warranty or undertaking, whether express or implied, is or will be made at any time by Principal Real Estate or its affiliates or any of their respective advisers, directors, officers, employees, representatives or other agents (“Principal Agents”) for any information or any of the opinions contained herein or for any errors, omissions or misstatements.

None of Principal Real Estate or its affiliates or any Principal Agents makes or has been authorised to make any representation or warranties, whether express or implied, in relation to Principal Real Estate or regarding the truth, accuracy or completeness of any of the information contained on this website at any time. No representation or warranty is given by Principal Real Estate, its affiliates or the Principal Agents as to the achievement or reasonableness of, and no reliance should be placed on any projections, targets, estimates or forecasts contained in the information on this website. Furthermore, nothing contained on this website is or should be relied on as a promise or representation as to the future. No reliance may be placed by any person for any purpose whatsoever on the information or opinions contained on this website or on its completeness, accuracy or fairness at any time.

Principal Global Investors (Europe) Limited is not authorised by the FCA to directly deal with retail investors; any distribution of the Fund to retail investors in Europe is facilitated by fund distributors with which Principal Global Investors (Europe) Limited has entered distribution arrangements, pursuant to advice provided to investors by those distributors, based on the documents Principal Global Investors (Europe) Limited provides. Retail investors should not be provided with access to this website.

The name of the Swiss representative is ACOLIN Fund Services AG, Stadelhoferstrasse 18, CH-8001 Zürich. The name of the Swiss paying agent is Banque Cantonale de Genève, 17, quai de l’Ile, 1204 Geneva. Investors can obtain the prospectus, trust deed, the simplified prospectuses and the annual and semi-annual reports free of charge from the representative in Switzerland.
The value of units and the income from them may fall as well as rise.

Investments in the Funds are neither insured nor guaranteed by the US Government or the Federal Deposit Insurance Corporation and are not deposits or obligations of, or guaranteed by, Principal Global Investors.

No Solicitation
Nothing contained in this website shall constitute an offer or solicitation, in relation to units in the Funds or generally, in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised.

In particular, shares issued by the Company, and units in the Funds, have not been and will not be registered under the United States Securities Act of 1933 as amended or the securities laws of any state or political subdivision of the United States and may not, except in a transaction which does not violate US securities laws, be directly offered or sold in the United States or to any US Person. The Company will not be registered under the United States Investment Company Act of 1940 as amended.

This website is reserved exclusively for non-US persons and should not be accessed by any person in the United States.

No Investment Advice
The information in this website contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such nor should it be construed as specific investment advice, an opinion or recommendation. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. Past performance is not a reliable indicator of future performance and should not be relied upon as a significant basis for an investment decision.

You should also inform yourself as to (a) the possible tax consequences, (b) the legal requirements and (c) any foreign exchange restrictions or exchange control requirements which you might encounter under the laws of the countries of your citizenship, residence or domicile and which might be relevant to any investment, including the subscription, holding, transfer or disposal of units in the Funds

Delegation of Investment Management to Affiliates

Products upon which composite results contained in this material, if any, are based may not themselves be available in the United Kingdom and certain other jurisdictions; however, the underlying investment management capability can be made available to institutional investors subject to all applicable local regulations and restrictions. In connection with its management of client portfolios, PGIE may delegate management authority to affiliates that are not authorised and regulated by the Financial Conduct Authority. In any such case, the client may not benefit from all protections afforded by rules and regulations enacted under the Financial Services and Markets Act 2000.

Disclaimer
The information on this website is given by Principal Global Investors in good faith and has been derived from sources believed to be reliable and accurate as at their date. However, Principal Global Investors makes no representation or warranty of any kind for the accuracy or completeness of the information and it is under no obligation to update or correct any errors in the information after the date of publication. This website also contains videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions.

Subject to applicable law, Principal Global Investors and its affiliates and their respective directors, employees and associates do not accept any responsibility arising in any way (including by reason of negligence) for errors in, or omissions from, the information and do not accept any liability for any loss or damage, however caused, as a result of any person relying on any information on the website or being unable to access the website.

The Internet is not a totally reliable and secure medium of communication. Principal Global Investors accepts no liability for the security or confidentiality of information transmitted in this way and any such transmission of information shall be at your own risk.

The entire content of this website is subject to copyright with all rights reserved. You may not copy, reproduce, distribute or modify the content of this website without the prior written permission of Principal Global Investors.

No instructions for investment purposes will be accepted directly from this website or by e-mail.

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You may view, download for caching purposes only, and print content from the website for your own personal use, subject to the restrictions set out below and elsewhere in these Terms of Use.

No Guarantee of Timeliness
This website may contain videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions. The information and materials contained on this website, and the terms, conditions, and descriptions that appear, are subject to change. All content on this website is presented only as of the date published or indicated, and may be superseded by subsequent market events or for other reasons. In addition, you are responsible for setting the cache settings on your browser to ensure you are receiving the most recent data.

No Warranties
The information on this website has been developed internally and/or obtained from sources believed to be reliable; however Principal Global Investors and its affiliates do not independently verify or guarantee its accuracy or validity. The information and services provided on this website are provided ""AS IS"" and without warranties of any kind, either expressed or implied. To the fullest extent permissible pursuant to applicable law, Principal Global Investors disclaims all warranties, including, but not limited to, any warranty of non-infringement of third-party rights and any implied warranties of merchantability and fitness for a particular purpose. Principal Global Investors does not warrant, either expressly or impliedly, the accuracy or completeness of the information, text, graphics, links or other items contained on this website and does not warrant that the functions contained in this website will be uninterrupted or error-free, that defects will be corrected, or that the website will be free of viruses or other harmful components. Principal Global Investors expressly disclaims all liability for errors and omissions in the materials on this website and for the use or interpretation by others of information contained on the website. Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions on this website.

If you have questions, please email us.

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"Principal Global Investors, LLC, the issuer of this website, is a branch registered in the Dubai International Financial Centre and is authorized by the Dubai Financial Services Authority as a representative office.

This website contains general information only on investment matters and nothing in this website is intended to constitute or form part of any offer or inducement to issue or sell, or any solicitation of any offer to subscribe for or purchase, any securities or investment products in the UAE (including the Dubai International Financial Centre) and accordingly should not be construed as such. Information in this website is not directed at you if we are prohibited by any law of any jurisdiction from making the information on this site available to you and is not intended for any use that would be contrary to local law or regulation. Products or services mentioned on this site are subject to legal and regulatory requirements in applicable jurisdictions and may not be available in all jurisdictions. Accordingly persons are required to inform themselves of and observe any such restrictions.

The information in this website is being made available on the basis that the recipient acknowledges and understands that the entities and securities to which it may relate have not been approved, licensed by or registered with the UAE Central Bank, the Dubai Financial Services Authority or any other relevant licensing authority or governmental agency in the UAE or elsewhere in the Middle East.

The information in the following website should not be construed as investment advice or a recommendation for the purchase or sale of any security. The value of investments and the income from them may fall as well as rise. Principal Global Investors, LLC and the other member firms of Principal Global Investors (collectively, the ""Firms"")* do not guarantee any investment results and there can be no assurance that the strategies employed will improve investment performance, and make no guarantee that a client's investment objectives will be achieved and no warranties or representations, expressed or implied, are made by the Firms concerning the benefits of these strategies discussed herein. The information in this website has been developed internally and/or obtained from sources that the Firms believe to be reliable; however, the Firms do not guarantee the accuracy, adequacy or completeness of such information and are not responsible for any errors or omissions. This website also contains videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions.

This website contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information it contains does not take account of any investor's investment objectives, particular needs or financial situation. Past performance is not a reliable indicator of future performance and should not be relied upon as a significant basis for an investment decision. You should consider whether an investment fits your investment objectives, particular needs and financial situation before making any investment decision.

Nothing in this website should be construed as investment, tax, legal or other advice.

The content of this website has not been approved by or filed with the UAE Central Bank or Dubai Financial Services Authority.

Access to this website is only permitted for ""sophisticated institutional investors/professional clients"". If you are not a ""sophisticated institutional investor/professional client"", you may not access this website and you should select the ""Decline"" link below.

By selecting the ""Accept"" button below, and entering this website, you agree to these terms and confirm and represent that you are a "" sophisticated institutional investor/professional client""."