Investors Currently Earning Outsized Returns in CRE Debt Funds

Takeaways

• Region banks have significantly cut back on smaller construction loans.
• There’s a opportunity for alternative lenders to fill the void left by regional banks.
• Real estate debt investments will outperform real estate equity investments.

Let me guess. You’re an investor looking for risk-adjusted returns that are outsized relative to the market. Oh, and it would also be nice if the holding period was relatively short. Where do you find something like that? Here’s an option for you: private credit, especially debt funds with a focus on construction lending for commercial real estate. Let me explain.

Who Turned off the Spigot?

The well-publicized failure of several very prominent regional banks last year is still rippling through the real estate industry. Do you remember the banking crisis of 2023? It was bad enough on its own, but when you combine that with the one-two punch of inflation and higher-for-longer interest rates, real estate developers suddenly find themselves in a tough spot. Most regional banks have essentially turned off the spigot, while the ones that are still originating construction loans have become much more conservative in their underwriting.

Up until very recently, regional banks were the primary source for smaller construction loans. By small, at least when it comes to construction loans, I mean up to about $50 million. Now that they’ve exited the market to a large extent, it’s creating an unusually attractive opportunity for alternative lenders that have expertise in construction lending.

It's a Lender's Market

The market is currently in a state of dislocation, one where the lack of liquidity is driving up yields and keeping loan-to-cost ratios low. From the perspective of an alternative lender – perhaps more importantly, from the perspective of their investors – from your perspective – it’s the best of both worlds. Think about it. You’re getting greater returns with less risk. When borrowers have fewer options, the dynamic shifts to favor lenders. In other words, it becomes a lender’s market. That’s where we find ourselves today, in a lender’s market. The ongoing gap between developer demand for financing and the availability of funds from traditional lenders is creating opportunities for alternative lenders to secure very favorable terms and pricing on short-term loans for construction and development projects.

Construction loans typically have a term that’s somewhere between one and three years. They might also have options to extend the term for short periods of time if needed. As an example of how things unfold, imagine that a developer is building a grocery-anchored retail center. During the term of the construction loan, the developer sequentially completes the project, leases it up to stabilized occupancy, and pays off the construction loan. That final step is sometimes accomplished by selling the property, but more often than not, it’s accomplished by refinancing into a permanent loan.

Underwriting the Developer

Now, to be clear, construction lending isn’t without risk. In fact, it generally represents a higher risk profile than other loan categories. This is due to the unique set of hurdles that developers must overcome in the course of business, everything from delays in obtaining entitlements to disputes with subcontractors. In order to be successful as a construction lender, you not only have to underwrite the development project, but you also have to underwrite the developer.

• You have to be selective, only partnering with a developer after doing sufficient due diligence to fully understand their expertise and capabilities.
• You have to look carefully at their track record and the similarities between past and current projects.

Of course, that’s the lender’s job. You’re an investor looking for outsized returns. That brings me back to debt funds.

Private Credit to Outperform

As it happens, we’re now in a transitory period of time when real estate debt investments are generally outperforming real estate equity investments. Recognizing these circumstances, private credit funds and other alternative investment managers are raising record levels of capital to fill the void left by banks. For these investment firms and their investors, the next couple of years are going to hold a plethora of opportunities to create and grow wealth by investing in private credit. If you’re looking for outsized returns, you’ve just found them.