Understanding private equity in multifamily real estate

The label “private” is most associated with those intending to limit their exposure to strangers on social media. But buried beneath its colloquial use is the exclusive exchange of goods and services with the expectation of future payment. 

For the novice accredited investor, private credit might be confused with private equity. However, private equity represents an ownership stake (acquiring part of a company/property and sharing in the returns and losses). In contrast, private credit merely represents a loan (a debt that must be repaid). [1] 

Private credit, a formerly lesser-known financial instrument in the industry, is a lending approach that distinctly differs from traditional banking. Therefore, it is critical to decipher its associated qualities, risks, and application to multifamily real estate.

PRIVATE CREDIT DEFINED

Ares Management CEO Michael Arougheti says that private credit “in its simplest form is private loans to privately owned companies, privately owned real estate, and privately owned infrastructure.” [2] If you’ve ever heard the tongue twister, “Sally sells seashells by the seashore,” the following example might simplify the characteristics of private credit.

As it turns out, Sally’s billion-dollar seashell operation is backed by the company Sally’s Seashells, which she privately owns and runs out of her oceanfront boutique. However, Sally will need additional funding to sell more shells. Since her neighborhood bank cannot loan her the significant capital she seeks, Sally’s friend Tommy (he trims timeworn trees near the terrace) suggests a private credit route. 

Sally meets with a private credit fund manager to learn if she can qualify for a direct lending opportunity. After the manager decides on lending terms based on various criteria unique to their fund, Sally receives the capital to continue selling seashells.

How can Sally qualify for private lending?

Sally qualifies because private credit funds are an alternative asset class comprising a pool of investors. Private credit can provide borrowers like Sally with a specialized, holistic financing solution. For investors, it can dole out passive income with superior returns due to higher interest rates. Private credit can thrive in a high-interest-rate environment because it is often a floating-rate product. So, as interest rates rise, private credit rates increase too.

By now, it is clear who might need to borrow from private credit institutions—individual borrowers like Sally or larger corporate borrowers. But who might invest in private credit, and what does it entail? Accredited investors, likely through their financial advisor, may learn of an opportunity to receive passive income by investing in an alternative asset class that has historically demonstrated straightforward, premium returns compared to traditional, fixed-rate markets. An accredited investor is an individual with an annual income of at least $200,000 (or $300,000 for joint income) or a net worth of at least $1 million (for both individual and joint net worth), excluding the value of their primary residence. Private credit institutions can mitigate risk and meet classification standards by limiting investments to accredited investors.

HISTORY OF PRIVATE CREDIT

Private credit was born in the 80s and has steadily grown over the last ten to fifteen years, rising in popularity after the Great Financial Crisis. In the following years, private credit sought to fill the gap left by traditional banks forced to adhere to strict regulatory changes for the global banking community. The crux of private credit’s history is its expansion into asset-based financing, a product previously exclusive to bank lending. Asset-based financing means the loan is secured by collateral (inventory, equipment, property, etc.). In Sally’s case, her loan is secured by her oceanfront boutique (property). [4]

PRIVATE CREDIT IN MULTIFAMILY REAL ESTATE 

Multifamily private placement (syndication) is a partnership involving multiple investors pooling funds to buy a multifamily property. This real estate classification consists of residential properties with four or fewer (but more than one) housing units, while commercial properties must have five or more housing units. For example, a duplex would be categorized as residential. However, a 100-unit+ apartment community would fall under commercial multifamily real estate. General partners (GPs) execute the business plan in this partnership, and investors/limited partners (LPs) assume a more passive role. 

While returns continue to outperform in this alternative asset class, as of 2024, the number of units coming online (listed for sale) for multifamily real estate has reached a 50-year peak; for lenders in the private credit sphere, this means development deals putting shovels in the ground today will need capital. 

In multifamily real estate, private credit can fund the construction of a new property. Similar to how Sally’s property was put up as collateral for her loan, many multifamily owners/operators, also known as sponsors, may seek a private credit loan to purchase or break ground on a multifamily community. In the same way, the mortgage for this multifamily community can act as collateral for the private credit that funds it. So if the owner/operator defaults on the loan (fails to repay according to the loan agreement terms), the private credit institution could take that property, sell it, and pay itself back. The multifamily default rate has historically been low relative to economic downturns. Newer market data shows variations in this measurement, which makes discussing risks of private credit a talking point in real estate roundtables.

PRIVATE CREDIT RISKS

No investment or loan is without risk. Private credit differs from the leveraged loan market. It benefits from a high interest rate environment because the yields of the income from private credit increase correspondingly with interest rates. This applies to its risk, too. In multifamily real estate, and generally speaking, private credit risks differ between the borrower, the lender, and the investor. 

The borrower takes on the risk of interest rate fluctuations and potentially losing their property. So, Sally can use her real estate to leverage a line of credit with the private lender, known as asset-backed lending. But if Sally defaults on her payments to the lender, they have the right to sell the asset acting as collateral (an oceanfront boutique) to pay themselves back. 

For the lender, risks may include the borrower’s creditworthiness and private credit market volatility as participation and growth outpace the industry’s bandwidth. 

Investors face illiquidity risks, meaning that until the loan matures, investors are held to the investment no matter its performance or may face high losses in the event of an emergency exit. [5] 

Besides knowing the difference between private equity and private credit, it is also essential to understand how debt impacts the global economy. As this non-bank lending asset class grows, borrowers and investors could benefit from reviewing risk/return profiles before entering a new deal. If you are an accredited investor who wants to enjoy passive income and all the other benefits of multifamily private placement, schedule a call with BAM Capital and invest today.

Disclaimer: All investments carry risk, including potential loss of capital. This content is for informational purposes only and is not financial, legal, or investment advice, nor an offer or solicitation to buy or sell any security. Consult an independent advisor for personalized guidance, and contact BAM Capital for details on current offerings. BAM Capital and its representatives are not fiduciaries or investment advisors. The information provided is general and may not reflect individual financial goals. Past performance does not predict future results. BAM Capital and its affiliates do not guarantee the accuracy or completeness of this information.

Sources: 

[1]: Investopedia. (24 May 2024). “Private Credit vs. Private Equity: What’s the Difference?” https://www.investopedia.com/private-credit-vs-private-equity-7565530

[2]: CNBC. (2024). “How Private Credit Became One of the Hottest Investments on Wall Street.” https://www.youtube.com/watch?v=nXyot2gnxqg

[3]: EquityMultiple. (4 July 2024). “Private Credit—A Timely Real Estate Investing Strategy.” https://equitymultiple.com/blog/private-credit#:~:text=Real%20Estate%20Private%20Credit%20Definition,This%20article%20will%20discuss%20why. 

[4]: National Association of Insurance Commissioners. (n.d.). “Private Credit Primer.” https://content.naic.org/sites/default/files/capital-markets-primer-private-credit.pdf

[5]: Board of Governors of the Federal Reserve System. (23 February 2024). “Private Credit: Characteristics and Risks.” https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html