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While many investors typically think of real estate investing in terms of real estate investment trusts (REITs) and direct investments in properties like homes, apartments and warehouses, there are other ways, including the private real estate space.
In the current interest rate environment, one of the most talked about areas within the private real estate sector is real estate credit, an asset class which has historically been relatively opaque and predominantly available only to institutional investors.
At a time when financial professionals are increasingly looking for differentiated alternative investment products for diversification1 and return benefits, these are the three things you need to know about the growing asset class.
Opportunity for non-correlated returns
One of the biggest draws to alternative investments in general, and a primary reason for the recent uptick in demand for these asset classes among investors, is their distinct risk/return profile and non-correlation to public markets.
Real estate credit is no different than other alternative investments in that regard.
Over the past 10 years, real estate credit has offered high single-digit income returns with significantly less volatility than REITs or equity and fixed income markets.2 This asset class has been around for many years in the institutional arena, and it has a track record of stable and non-correlated returns. Specifically, private real estate credit has delivered an 8.5% annualized total return, in line with direct lending and real estate equity strategies, but with significantly lower volatility.3
This return profile is derived from several sources:
- Returns are derived from current income, which comes from interest payments made by the borrowers on the underlying loans.
- Loans are made at conservative leverage levels (on average 65% of the value of the underlying property) and in the most senior portion of the capital stack, with the goal of providing insulation in the event of a real estate price correction.
- Because loans are secured by hard assets, the asset class has historically benefitted from a low loan default rate when compared to other lending products.4
One of the largest and most well-established fixed income asset classes
Historically dominated by banks, insurance companies, and government agencies (Fannie Mae and Freddie Mac), real estate credit was the fourth largest fixed income asset class in the U.S. as of 2023.5 This six trillion-dollar asset class eclipsed the municipal bond market in size, but has so far been difficult for retail and high net worth investors to access.
The asset class is also growing, with expectations for record high loan demand over the next four years, right at the same time as many of the traditional dominant players, such as banks, are expected to be less active in the space. While insurance companies and institutional investors continue to increase exposure to private real estate credit, new investment vehicles are continuing to emerge in the space to fill the gap. As a result, the asset class is becoming more accessible to high net worth and retail investors.
A unique window of opportunity
Since the Silicon Valley Bank crisis, the traditional lending industry has been tightening their lending standards across the board in response to higher interest rates and inflation, which has created a mismatch between credit supply and demand for the real estate industry.
With regulatory pressure and tightening standards limiting banks’ ability to meet the demand for lending in the space, private lenders have a distinct opportunity to fill that void and capitalize on a “higher for longer” interest rate environment which has historically been positive for real estate lending.6
Alternative lenders also have a track record of keeping the market share that they’re able to claim from traditional lenders, because they are more nimble and flexible, can structure deals in different ways, and are by-and-large more responsive and adaptable to the needs of their borrowers – which means that, while we are entering a prime opportunity for this asset class, it’s also temporary.
Seizing the opportunity
Private real estate credit is by no means a new asset class, but it may well be new to you and your clients. As with any investment, especially alternatives, ensuring that both you and your clients have a thorough understanding of the asset class is crucial.
Retail access to this asset class is only in its infancy, but it has emerged as a powerful option for investors seeking to fortify and help diversify their portfolios against what has been a volatile public market ecosystem by increasing their exposure to alternatives.
Charlie Rose is a managing director and global head of debt at Invesco Real Estate. He leads the firm’s commercial real estate credit lines of business globally. Charlie is a member of the North American Credit Investment Committee and the European Credit Investment Committee and chairs both the firm’s Investment Strategy Council and its Diversity, Equity & Inclusion Taskforce.
1 Diversification does not ensure a profit or protect against loss.
2 Invesco Real Estate using data from the following indices: Direct Lending – Cliffwater Direct Lending Index, Private Real Estate Debt – Giliberto-Levy High-Yield Real Estate Debt Index (G-L 2), High Yield – Bloomberg US Corporate High Yield Index, Senior Loans – Morningstar LSTA Leverage Loan 100 Index, Private Real Estate Equity – NCREIF Property Index, Corporate Bonds – Bloomberg U.S. Corporate Total Return Value Unhedged USD Index, CMBS – Bloomberg US CMBS Investment Grade Index, Investment Grade Bonds – Bloomberg U.S. Aggregate Total Return Index, Treasuries – Bloomberg U.S. Treasury Total Return Unhedged Index, and US Equity – S&P 500 Index. Trailing 10-years of data, last 10 years of quarterly returns annualized 2013Q3-2023Q3, latest data available. Average Distribution Yields: Direct Lending, 10.25%; Private Real Estate Debt, 9.33%; High Yield, 6.50%; Senior Loans, 5.46%; Private Real Estate Equity, 4.58%; Corporate Bonds, 3.42%; CMBS, 2.95%; Investment Grade Bonds, 2.63%, and Treasuries, 1.94%. Sharpe Ratio: Private Real Estate Debt, 4.51, Direct Lending, 2.51; Private Real Estate Equity, 1.41; US Equity, 0.74; Senior Loans, 0.52; US High Yield, 0.40; CMBS, 0.19; Corporate Bonds, 0.14; Investment Grade Bonds, 0.02 and Treasuries, (0.07).
3 Invesco Real Estate using data from the following indices: Private Real Estate Debt – Giliberto-Levy High-Yield Real Estate Debt Index (G-L 2), Direct Lending – Cliffwater Direct Lending Index, Private Real Estate Equity – NCREIF Property Index, Trailing 10-years of data, last 10 years of quarterly returns annualized 2013Q4-2023Q3, latest data available. Annualized Total Return: Direct Lending, 8.87%; Private Real Estate Debt, 8.51%, and Private Real Estate Equity, 7.40%. Sharpe Ratio: Private Real Estate Debt, 4.51, Direct Lending, 2.51, and Private Real Estate Equity, 1.41.
4 Invesco Real Estate using data from the following indices: Direct Lending – Cliffwater Direct Lending Index, Private Real Estate Debt – Giliberto-Levy High-Yield Real Estate Debt Index (G-L 2). Trailing 10-years of data, 2012Q1-2022Q4, latest data available. Credit Loss Rate: Direct Lending, 0.90%, and Private Real Estate Debt, 0.21%.
5 SIFMA Q4 2022 for Treasury, Corporate, Municipal $’s Outstanding. SIFMA Q4 2021 for US MBS $’s Outstanding. St. Louis Fed Q1 2023 for Commercial Real Estate Loans $’s Outstanding. As of March 31, 2023, most recent data available.
6 MacroTrends as of November 30, 2023.
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