Why is Private Credit Hitting the Spotlight?

Private credit is in a race, and it’s now near the front of the pack, moving from a niche to a core asset class for institutional and savvy individual investors. There are many options in this space, but real estate credit is, in my opinion, the best.

Private real estate credit offers high fixed-rate income with controllable risk in a niche market being left behind by traditional lenders. This has been true for the 17 years I’ve been in business, but the space is now growing in a big way. The current size of the private credit market is roughly $2.1 trillion, with expectations of that doubling by 2030, according to BlackRock and other credible sources. Real estate represents a large portion of that market.

Why Private Credit Is Gaining So Much Momentum

• Bank retrenchment. This has been a common theme for as long as I can remember, but it has been magnified since 2020. Increased regulation, higher capital requirements, and a decreasing appetite for lending have all played a role. Global regulations such as Basel III have caused banks to become more conservative, especially with short-term borrowers and real estate investors. This has created tremendous opportunity for direct lenders like Pine Financial Group.
• Institutional endorsement. Managers like BlackRock and Blackstone have poured resources into private credit to bring consistency to their investment suites. For example, Blackstone reported continued inflows of over $52 billion last quarter alone.
• Attractive income. Unlike many assets where you need to sell to realize gains, private loans create quarterly, and sometimes monthly, income for investors. Stable income has become a top priority for investors in recent years, particularly with an aging population and the uncertainty of public markets. Even younger investors are prioritizing income over speculative growth.
• Diversification. Adding income to an overall investment strategy is just smart. I often hear investors say they’re diversified because they own mutual funds invested in several different assets. The problem is that those assets are often highly correlated, so that’s not true diversification. The stock market has even become more concentrated, with the top seven companies now making up about one-third of the S&P 500. True diversification that reduces risk must involve both public and private investments, and both equity and debt. In other words, invest in Wall Street and Main Street.

Risks

As great as it is, private credit does carry some risks. Here are the top risks to consider, and why choosing an experienced manager and a solid asset class matter.

• Default risk. This is easily the number one risk with any kind of credit investment: will the borrower pay back the loan with the agreed-upon interest? Fundamentals matter. According to Fitch, the estimated private credit default rate is around 4.6%. Anything under 5% should generally keep your investment relatively safe, but that’s only true if the underlying asset is of high enough quality to limit losses.
  For example, because we secure our loans mostly with residential property, we’re able to liquidate assets quickly, and often for more than the loan amount, in the event of a default. While we never want this to happen, in some cases we actually make more money on a loan when it defaults.
  I put residential real estate in the lower-risk category, while riskier credit profiles include loans secured by large commercial assets or business loans backed by equipment or accounts receivable. I strongly believe residential real estate is the best collateral option, but even then, solid underwriting and conservative loan-to-value ratios are key to managing risk.
• Liquidity risk. Most private credit vehicles are not liquid. Many have semi-liquid structures, which may include limiting redemptions per month or quarter, as well as lag times between a redemption request and the manager’s ability to satisfy it. Understanding these terms—and the manager’s track record for fulfilling redemptions—is important.
• Leverage. As this space grows in popularity, banks and other creditors are getting involved. Some lenders now loan against loans, meaning the notes in a private credit fund are used as collateral to increase lending capacity. This can enhance returns by creating spreads, but any added leverage introduces additional risk.
  If the market turns, these lenders could call their loans due, putting pressure on fund managers. If a private credit manager defaults on payments, the bank could repossess the notes, putting investors’ capital at risk. It’s generally wise to keep leverage low.
• Concentration. This one is nuanced, as there are differing opinions. Through our interviews with investment clubs, Passive Pockets, and other financial institutions, we’ve seen that some believe in a highly diversified portfolio, while others believe loans should be concentrated in markets and asset classes the manager understands best: “invest in what you know,” as Warren Buffett says.
  For us, we prefer an 80/20 balance between commercial and residential assets. We favor residential because it’s the most liquid and easiest to sell if needed. Maintaining low concentrations to any one borrower or deal is also important. Many fund managers do not set concentration limits in their underwriting, which adds unnecessary risk for investors. Again, it all comes down to understanding what’s in the private credit portfolio you’re investing in.

Due Diligence and Management

It’s important to remember that “private credit” is just a wrapper: what you’re lending against determines both the risks and the outcomes. There are also many different fund structures, with some concentrating on growth and others on cash flow. Your goals should guide you toward the right fund.

Beyond the loans and underlying assets, the manager of the private credit fund is the most important factor to evaluate. I always start with a quick Google search of the fund and its management team to identify any red flags that would cause me to immediately pass on the opportunity. From there, I dig deeper. I want to know their track record and how they’ve handled challenges in the past. No private credit fund performs perfectly all the time, so understanding how management has responded to adversity can indicate how they’ll handle future problems.

Next, I review the reporting and transparency of the fund, followed by a careful look at the legal documents. Fully understanding what you’re signing before investing is essential. I look for clauses related to capital calls and liquidity, as well as past performance, projections, and underwriting and servicing standards.

I’m often surprised by how many real estate lending funds lack written underwriting guidelines or even advertise that they offer “non-qualifying” loans.

Final Thoughts

If you’re interested in cash flow, high risk-adjusted returns, additional diversification, and stability, private credit may be an excellent investment option.