Originally posted by Fundrise on May 02, 2023
The aftereffects of a 15-year expansionary monetary policy, combined with the recent dramatic rise in interest rates, have led to a once-in-a-decade investment opportunity in private credit.
Background Private credit (or private lending) is an asset class that consists generally of loans, fixed income, or other structured investments that aim to deliver higher yield with lower overall risk when compared to equity investments. In other words, investors in private credit are loaning money to borrowers in exchange for a fixed rate of return (often captured in the form of an interest rate or preferred return) but typically do not have any equity ownership or upside participation. Similar to other private market assets, private credit differs from publicly traded credit or fixed income investments, such as bonds, in that it is illiquid and as a result generally aims to deliver a higher relative return.
Strategy Over the past 15 years, the global financial markets have experienced a period of record low interest rates and generally accommodative monetary policy. During this time debt has been relatively inexpensive, and borrowing has been readily available. As a result, up until mid 2022, equity has generally been the more attractive investment class, with the equity risk premium (a measure of the expected additional return one would earn from investing in equities above and beyond treasuries) maintaining one of its largest spreads over the past 20+ years.
To put it simply, for much of the last cycle, all fundamental indicators suggested that credit as an asset class was relatively less attractive than equity.
However, over the past 12-18 months with the re-emergence of higher inflation (for the first time in more than 30 years), the Federal Reserve has been forced to reverse their previous policy, rapidly raising interest rates and beginning quantitative tightening (removing liquidity from the market). This dramatic shift in policy has destabilized markets, leading to broad dislocations, increased strain within the financial system, and a potential liquidity crisis that presents both a risk to the global economy while simultaneously creating arguably the most attractive environment for credit investments in a generation.
10-year real yield is the yield on 10-year US treasury inflation-protected securities (TIPS), sourced from St. Louis Federal Reserve Economic Data (FRED). S&P 500 earnings yield is the inverse (E/P) of the historical S&P 500 PE ratio, sourced from Macrotrends.
Leveraging and deleveraging
Like a balloon filling with air, inexpensive borrowing costs created by expansionary monetary policy have the direct effect of inflating asset prices and creating significantly more leverage (i.e., debt) in the system. But as those policies are reversed and air is released, borrowing shrinks and debt must be paid down.
To illustrate this point, imagine that in the fall of 2020 a real estate investor acquired an apartment building for $100M. At that time, they may have chosen to use a bridge loan for the acquisition and as a result were able to borrow up to $75M (a 75% loan-to-value) at a 3% interest rate.
Now, roughly 3 years later, that loan is coming due, and in today’s borrowing environment the investor is only able to get a loan of $55M (a 55% loan-to-value), with a new interest rate of 6%.
Even if we assume that the property has been operating well over this time period and there aren’t any issues or concerns, simply because of the change in the lending environment the borrower will still need to increase their equity in the deal by $20M just to complete a refinancing.
Given that the borrower had originally invested $25M (i.e., 25% of the original asset value), this additional $20M of new equity represents a roughly 80% increase. Imagine, for a moment, if homeowners had to come out of pocket with cash to increase their equity (pay down their mortgage) by a similar amount… most likely most could not do it.
Not to mention that the interest payments on the loan will be nearly 50% higher, which means that in many cases all the free cash flow that previously had been paying the investor’s return will now have to go to just paying the monthly interest. This process of rising borrowing costs, more conservative lender requirements, and generally less debt being available is exactly what is occurring today — we call it The Great Deleveraging — and while it’s creating a wave of potential distress for borrowers, it’s simultaneously driving attractive opportunities for credit investors.
We call it the “great” deleveraging because rather than being limited to any one asset or industry, nearly every borrower and every asset (regardless of credit quality) are being impacted. No matter who you are, if you were active in business over the past several years then you were inevitably borrowing to some extent. And if you were borrowing, then you were borrowing at historically low rates and relatively high asset values.
Now, in the new environment, regardless of the quality of the underlying asset, as loans mature and come due, there will be a gap created during any financing event that must be filled by new capital.
This gap will create opportunities, especially for investors who are well capitalized and fortunate enough to be in the position where they can afford to be on the offensive.
And because these gaps have little to do with actual credit quality, particularly attractive opportunities are expected to emerge where one can earn a much higher relative return in relation to the actual underlying risk. In other words, during this period investors (acting as lenders) will likely be able to earn higher returns than previously despite being invested in lower risk positions (i.e., lower leveraged loans), in assets with strong long-term fundamentals.
A window in time Like most opportunities for substantially outsized risk adjusted returns, we expect this period to be short-lived.
Today, it is more expensive to borrow money for one month than for ten years. This unnatural state, known by many as an “inverted yield curve,” signals that the market believes either inflation will fall dramatically in the near future or that the economy is headed for a recession and that either way interest rates will eventually stabilize much lower. As they do, this window of opportunity will eventually close. Historical Treasury rates sourced from St. Louis Federal Reserve Economic Data (FRED). Forecast based on FOMC projections for the Fed Funds rate and Fundrise internal analysis of Treasury spread behavior from historical yield curve inversion events.
As fundamentally driven value investors with a deep level of paranoia, we intentionally built the Fundrise portfolio to be prepared not only to weather the downturns that inevitably arise in cyclical markets, but, just as importantly, to be positioned to act with speed and agility as these types of unique, generational opportunities arise.
Having acquired or invested in nearly 40,000 residential units across the Sunbelt and built a decade-long track record with many of the top banks and capital market brokers as a reliable (and, just as importantly, non-predatory) provider of preferred equity and other gap financing solutions, we’re well positioned at the center of activity. (Note: At this moment we are seeing more attractive gap financing investments than we are able to fund.)
While private credit is a foundational component of a well balanced alternative asset strategy, we believe the opportunities that exist at this moment in time, specifically for asset backed credit investments that we are pursuing, are unique and unlikely to repeat in the future.
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