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
Disclosure

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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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