Can (Jon) Tavsanoglu, Founder & Chief Investment Officer at Caldera Real Estate Ventures, an external CIO & Asset Management Platform.
Private debt or credit refers to financing from private funds or alternative capital sources as opposed to traditional banks, bank-led syndicates or public markets.
Private funds employ strategies like direct lending, venture debt or special situations financing (including bridge, gap and rescue financing) for both listed and unlisted companies, as well as real assets like infrastructure and real estate. These investments can take the form of senior, junior, mezzanine, unsecured debt or preferred equity.
While private debt has been around since the turn of the 20th century, its user has been steadily increasing in recent years, especially after the global financial crisis (GFC) in 2008.
The 2008 bailouts and bankruptcies led to new bank regulations in the U.S., which were further augmented by the international regulatory committee rules. Basel III established new capital guidelines and liquidity requirements for banks, focusing on credit risk and forcing banks to reduce their high-risk CRE exposure.
That’s where private lenders have stepped in.
Market Conditions In 2024
Due to the following market conditions and further tightening of available credit, I think private debt utilization is likely to continue:
1. Rising Interest Rates
The U.S. CRE market was able to expand after the GFC because interest rates were close to 0% for years. While rates slowly increased to around 2.5% in 2019, they were reduced to 0.25% again during the pandemic. This contributed to record-high valuations for CRE until the Fed adopted its aggressive anti-inflation policies in 2022, which led to 11 consecutive rate hikes, taking benchmark rates in a range of 5.25% to 5.50%.
We can see the immediate effects of the rapid rate increase in the renegotiation of property valuations between sellers and buyers for existing deals. Lenders lowered their loan proceeds and tightened their overall lending criteria. As a result, many transactions had to navigate through the complexity of gaps created in their capital stacks.
2. Regional Bank Failures
Big bank failures in 2023 had a significant effect on the economy and highlighted the systemic risks in the banking system. To fight regulatory scrutiny, many banks are increasing their reserves and reducing their CRE risk exposure, which will result in further tightening of credit markets in 2024 and 2025.
3. Loan Maturities
Nearly $1.2 trillion in CRE loans are scheduled to mature by the end of 2025. However, borrowers who have to refinance are likely to encounter major challenges like higher borrowing costs, declining property values and tightening credit conditions.
Predictions And Market Opportunities
There have been many predictions about the Fed’s rate policy, inflation, rate cuts and whether a “soft landing” (referring to a mild or lack of recession) is achievable. The positive outlook on inflation at the beginning of 2024 led to some predicting up to three rate cuts by the end of the year.
However, recent mixed news caused the Fed to keep the rates unchanged, lowering the rate cut possibility to one by the end of the year. If the reality becomes “higher interest rates for longer,” that would likely increase the pressure on real estate assets and borrowers while causing traditional lenders to continue limiting their lending activity.
Capital stack gaps are already creating a lot of distress, even for A-class properties with healthy cash flows. Hence, we couldn’t realistically live in an environment where there is very limited leverage for another two to three years.
So, who is likely to finance these capital stack gaps? Below are some areas where investors may find compelling opportunities within private debt.
Existing Loan Modification Capital
For those with quality cash-flowing assets with maturing loans and looking to negotiate a loan extension with their current lender, the new subordinate capital could replace the equity injection expected from the borrower, facilitate new interest cap purchases, replenish the interest reserve for the senior loan and pay for other financing closing costs.
Bridge To Value Add Capital
Private debt is also likely to come in as bridge financing to fund crucial capital expenditures to combat vacancy, renovate units or increase operating income through other value-added strategies like creating amenities or implementing operating expense-reducing systems.
Investment Horizon, Returns And Considerations
If the banking system stabilizes in the next few years and we return to traditional valuation metrics, the opportunity for private debt will likely then have a limited window. Investors may be able to originate two-year loans with a one-year extension that could generate 14% to 15% coupons. Coupons may be a combination of accrual and current pay.
Overall, investors should be aware that the private lender market is crowded with sophisticated debt fund players, and certainty of closing, as well as the ability to close in a fast manner, makes the difference when being awarded a deal. However, family office investors could create serious competition as originators because they have flexible capital and could potentially offer lower coupons/more freedom to borrowers, while debt fund investors have rigid expectations.
Investors should also be cognizant of the complexity of these preferred equity structures, as there can’t be a one-size-fits-all approach. Every deal is unique, and the underwriting of the borrower and the underlying asset/cash flows is crucial.
On top of this, conducting basis analysis for both preferred equity and the whole deal is important. It’s important to stress-test key assumptions such as exit cap rates, refinancing metrics, operating expenses and the implementation of value-add and capital improvement plans. Some more complex business plans could require hands-on asset management from the investor as well as close monitoring of loan covenants.
In conclusion, there are considerable risks in private debt capital investments; however, we may be approaching a limited window of superior risk-adjusted return opportunities.
In light of this, deals may be creatively structured with a private debt instrument in the first few years, with an opportunity to convert to common equity later—for most family offices are long-term investors in cash-flowing assets. Borrowers are likely to take these “more friendly” terms with a potential long-term partner over a rigid lender that applies daily pressure.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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