Pros and Cons of Private Credit Investing for Real Estate Professionals

Introduction

Private credit funds are becoming the go-to investment choice for institutions and high-net-worth investors. The reduction in traditional bank lenders over the past few years has created attractive investment opportunities in the private credit real estate space.

In the context of commercial real estate, private credit involves investors putting their capital into a fund that lends money to commercial real estate borrowers at interest rates typically ranging from 14-20%. These loans are expected to be repaid in 1-5 years. Fund managers then pass much of the interest earned to investors, creating a continuous investment cycle. Investors are completely passive after they make their investment and can look forward to monthly cash flow distributions. 

Pros

Cash Flow: If cash is king, cash flow is the prince in shining armor. Realtors and other real estate professionals often experience fluctuating income, with some months or years better than others. An investment that produces consistent monthly cash flow can be a huge advantage, helping smooth out income variability. A private credit fund can produce 9%+ yearly cash flow, and more when considering overall returns. Stocks on the other hand, generally only produce less than 3% yearly cash flow, and can be extremely volatile and are not backed by a hard asset.

Low Risk: Capital preservation should be the primary goal for any investor. According to the Federal Reserve Bank of St. Louis, the likelihood of commercial real estate borrowers failing to repay their loans is less than 2% in most years,minimizing the risk of capital loss. Additionally, your capital will be spread across the entire fund. Even if one borrower defaults, you would still be protected by the performing loans in the fund.

Risk-Adjusted Return: Risk-adjusted return is a useful concept best explained through an example:

• Deal A: A ground-up development deal that produces zero cash flow for 3 years, still needs city approval for building plans, and expects to pay a 15% overall return to investors.

• Deal B: A private credit fund that makes low-risk loans to reputable borrowers, with an expected return of 13%.

  
  

Deal A projects a higher return but comes with significant risks, such as city approval issues, neighboring property objections, and rising construction costs. Deal B offers a slightly lower return but comes with much lower risk.

The higher risk-adjusted return is clearly Deal B. This illustrates the value proposition of a private credit fund: it provides an attractive risk-adjusted return.

Cons

Lower Overall Returns/Potential Upside: Overall returns generally range from 9%-14%. Many multi-family common equity investments project 15-20% annual returns. However, private credit fund loans have repayment priority over common equity, making them less risky than common equity investments. 

Taxes: Real Estate Professionals often face high taxes on their income. Unfortunately, private credit funds don't receive the same tax treatment as common equity investments, so investors miss out on these benefits. The Shining Rock Equity partners pair their private credit fund investing with other investments that do have tax advantages-but that’s for a different article!

Illiquidity: Many funds and real estate investments require you to keep your money invested for a set period before you can access your initial capital invested. This ensures fund managers don't have investors treating it like a high-yield checking account.

Conclusion

In conclusion, private credit investing offers compelling benefits and considerations for real estate professionals. The stability of monthly cash flow and low risk of capital loss make it an attractive option, particularly in volatile economic environments. The risk-adjusted returns of private credit funds often outshine traditional real estate investments, providing a predictable income stream while mitigating potential downside scenarios. Ultimately, the suitability of private credit investing depends on an investor's risk tolerance, income needs, and overall investment strategy within the real estate sector.

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