The Rise of Private Credit in Commercial Real Estate

April 11, 2025

 Following the 2008 financial crisis, stringent regulations, such as the Dodd-Frank Act, imposed capital and liquidity requirements on banks, restricting their ability to lend, particularly in the commercial real estate (CRE) sector. This regulatory shift, coupled with post-crisis bank consolidations, created a significant financing gap that private credit providers were quick to address. Since late 2021, the CRE industry has undergone substantial changes driven by rising interest rates, tighter liquidity, and evolving investor strategies. Amid this changing environment, private credit has emerged as a vital financing tool, offering both new opportunities and unique challenges for investors and borrowers alike.

Impact of Rising Interest Rates and Tightened Liquidity

Central banks worldwide, including the Federal Reserve, began steadily increasing interest rates post-2021 to counter inflationary pressures. These rate hikes significantly raised the cost of borrowing, resulting in a cooling effect on commercial real estate transactions. For instance, U.S. commercial property values fell by 9% in the latter half of 2022 according to leading analytics provider, Green Street.

Simultaneously, liquidity tightened as traditional lenders, notably regional banks, reduced their exposure to CRE loans. This was particularly evident in office real estate, which faced surging vacancy rates driven by a shift to remote work. This lending pullback created a gap in financing that private credit providers have stepped in to address.

Private Credit’s Role in the Market

In response to the changing market dynamics, private credit has gained prominence as an alternative financing solution. Investors have been drawn to the potential for higher yields, with levered returns on private credit investments reaching approximately 10% to 12%, especially through senior secured, first lien credit. This yield is particularly appealing when compared to the subdued returns from traditional fixed-income investments.

The flexibility inherent in private credit arrangements has also been a significant draw. Private lenders can tailor loan structures to meet the specific needs of borrowers, offering customized terms that are often more adaptable than those of traditional bank loans. This adaptability has made private credit an attractive option for borrowers facing challenges in securing financing through conventional channels.

Preferred Equity as a Growing Hybrid

Preferred equity is increasingly viewed as another powerful tool tapped by private credit investors. While not exactly a credit position, Preferred Equity site between debt and common equity in the capital stack, preferred equity prioritizes returns for investors while assuming less risk than common equity holders. Yields typically range from 12% to 15%, depending on the project’s risk profile and market conditions.

Preferred equity offers an opportunity for investors to tap into high-risk, high-return projects, serving as a financing bridge for borrowers amid tightening bank lending standards. For distressed or repositioning assets, it provides a unique blend of downside protection, and equity-like returns, making it an attractive option in today’s CRE environment.

For common equity investors, the inclusion of preferred equity introduces an additional layer of risk. Preferred equity ranks higher in the capital structure, meaning preferred investors receive returns and principal repayments before common equity holders. This priority reduces the cash flow and exit proceeds available to common investors, particularly if the investment underperforms. Accrued preferred returns can further diminish payouts to common equity holders, and certain structures even grant preferred investors control or conversion rights if payments are missed. While preferred equity can boost returns and lower the sponsor’s equity requirements, it significantly increases the downside risk for common equity investors.

Leveraged Private Credit for Equity-Like Returns

One of the most notable developments in the private credit space is the pursuit of equity-like returns through leveraged lending. By employing leverage, private credit funds have enhanced their return profiles, achieving gross internal rates of return (IRR) in the range of 14% to 15%. This strategy has positioned private credit as a compelling alternative to equity investments, offering similar return potential with a different risk and capital structure profile.

Strategic Considerations for Investors

For family office investors, wealth managers considering private credit, several key factors must be carefully analyzed:

• Underwriting: Thoughtful approaches to historical performance and benchmarking in the current.
  
• Due Diligence: Assess creditworthiness rigorously to mitigate risks associated with complex capital structures or asset challenges.
• Risk Management: Evaluate the impact of leverage and market volatility on investment performance, particularly during economic downturns.
• Diversification: Balance exposure through a mix of property types, geographies, and operator profiles to reduce portfolio vulnerabilities.

Private credit’s rise underscores its pivotal role in today’s commercial real estate market by compensating for traditional lenders retreating from CRE financing. Amid volatile conditions, strategies like preferred equity and leveraged lending have equipped private credit investors to pursue enhanced returns while providing critical capital to CRE projects that banks cannot currently serve.

The future of private credit within CRE is poised to expand further, requiring investors to remain diligent in aligning opportunities with their risk tolerance and strategic objectives. With the evolving dynamics of CRE financing, private credit continues to solidify its position as an essential instrument for navigating the challenges and opportunities in this space.

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