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Blog: A Strong Case for Private Credit


In the latter half of 2022 and into 2023, capital flew in droves to money markets and short term treasuries as higher than expected inflation forced the Fed to invert the yield curve with a round of historically sharp interest rate hikes, pushing the short rate (SOFR) to 22 year highs.


Although inflation was largely an issue of constrained supply with lingering COVID-19 supply chain issues, the Fed needed to act in response to pressure so they could satisfy expectations. This move effectively bankrupted the banking system because prior to covid, the FEDs sentiment and telepathy was low sustainable 2% inflation and low rates to stay along with it. In response, banks and various companies in the business of producing safe returns to meet financial obligations were encouraged to invest/lend long in search of bonuses and yield spread. Unfortunately, not many of them hedged their interest rate risk.


The sudden increase in risk-free rates of return are throwing equity markets for a spin, sucking liquidity out of the banking system, and threatening risk asset values as well as fixed income alike.


Increasing risk-free yields are putting upward pressure on existing variable loan servicing costs through higher annual debt servicing, stressing real estate free cashflow, (variable loans are priced at a spread over the SOFR index), and they are also forcing investors to scrutinize their yield & growth expectations. Ultimately, cap rates are expected to expand to meet the risk-reward expectations in the market. How much they will expand, if any, is a function of capital flows and future growth expectations. This comes at a time when inflation is putting upward pressure on operational expenses such as taxes, insurance, energy, utilities, precious metals, and labor.


The resulting effect? Decreased NOI, lower property values, and a large disconnect between buyers and sellers. In many primary, secondary, and tertiary growth markets, expense growth has outpaced revenue growth year over year and threatens to do so through 2025 based on forecasted growth outlooks in select markets. Several Apartment REITS have reported lower than expected Q3 earnings due to revenue and expense pressures suppressing net income growth. On average, NOI across $100B of major apartment REIT values has missed projections by 28%.

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Source: CRE Analyst


Investors who put bridge debt on assets in 2021 are under immense pressure to takeout their loans that are coming due this year and next. Given that NOI is down and cap rates are up, it is becoming increasingly hard to refinance these loans without the borrowers infusing cash into deals. Over the last decade, investors became accustomed to cash-out refinances, in which new loan proceeds exceeded that of the old loan amount, creating equity and value for partners. With interest rates climbing and threatening to remain elevated, we may see a wave of deals whose NOI are not high enough to support leverage that exceeds principal loan balances.


Multifamily values have come down from their peak, anywhere from 15-25%, depending on the market, asset class, and property level grade + characteristics. But since the private market and real estate in general is relatively illiquid, sellers can hold to prevent portfolio mark-downs and losses, just as long as they have good debt. The public REI market trades based on expectations and given its liquid nature, it tends to be a forward looking indicator for the private real estate markets.

In almost all of 2021, SOFR remained at 0% and the 10 year hovered under 1.5% for the majority of the year. Core, new multifamily assets in growth primaries traded as low at 3.25-3.5% cap rates.


Fast forward to 2023, and SOFR stands tall at 5.3% while the 10 year stands at 4.63%, an exorbitant increase, the sharpest rise in multiple decades. This increase in debt capital helps explain why sellers are not meeting the value expectations of current buyers in the marketplace. Buyers are underwriting to a much higher weighted average cost of capital, and sellers are in denial when you tell pricing is down 15% + from their expectations just months ago.

In time of value uncertainty, it pays to move down in the capital stack. Defensive positioning can help insure capital remains hedged from material swings in value, holding its value until the market heads back up. The chart below illustrates the changes in capital financing and return requirements, as well as leverage demands.

In the chart above, you can assume that the first position loan is a bridge loan. Once the Fed raised the short-term interest rate in one of the fast rate hiking accelerations in history, values began to wither, leverage receded, and equity became more hawkish. Weighted average costs of capital increased, putting pressure on free cashflow, valuations, and newly sized loan proceeds.

2021 rewarded investors for taking on more risk, sitting in a common equity position. It was common to see 15-20%+ annualized returns for vintage multifamily deals bought at reasonable prices and resold or flipped 2-3 years later. Many of these properties produced even higher equity returns, producing MOICs of 2-4x in less than 3 years. A combination of compressed cap rates and historically high rent growth produced these returns.


In 2023, case dependent, investors can command equity-like returns for debt-like risk, sitting in a preferred equity position in the stack. Similarly, senior first position lenders can command equity like yield while receiving a higher margin of safety on their leverage position. This capital stack dislocation became larger as debt-capital from banks dried up, and its expected to get even worse, leaving a gap and opportunity for those that are able to see it. Equity has to offset the decrease in leverage, hurting projected returns on much larger tranches of equity, driving yield expectations up even higher and pressuring values.


The risk-reward ratio largely favors credit or preferred equity in this environment because investors can earn a higher return for much less risk. We call this asymmetric, meaning, your potential for upside is higher than your risk of downside.

Historically, debt is uncorrelated to the value of the underlying real estate itself, as shown in the image below. AEG believes that debt and preferred equity is the most attractive vehicle at this point in the market cycle; although, equity opportunities are just starting to be compelling.


Once the market has confidence in future inflation, then it can rely on a terminal rate in order to confidently move forward with trades. Real estate transactions rely on an efficient and liquid banking system to function - & when debt dries up, appraisers and buyers alike cannot rely on prior trades to establish values... and lenders are not issuing any favorable term sheets either with deteriorating property and capital market level fundamentals. The result is a chain-effect of pressure build up.


Since bank debt issuance is a function of healthy collateral and reliable markets, we are likely to continue to see turbulence until something breaks or the Fed lowers rates. Until/if then, it will pay off to be lower in the capital stack as investors look for alternative debt solutions to fill the gap left by traditional lenders.

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Why Residential?

By Christian O'Neal • February 13, 2025
The fundamental need for housing is universal—everyone requires a roof over their head. In the United States, however, we are facing a significant shortage of housing. According to the National Multifamily Housing Council, an additional 4.3 million units will be needed by 2035 to meet growing demand. Much of this demand is driven by migration to expanding lower cost cities and away from high tax, high cost metros, a trend accelerated by the widespread adoption of remote work during the pandemic. This trend has reshaped the housing landscape, creating a compelling opportunity for investors. While there are numerous investment strategies available, each with its own set of risks, residential real estate stands out. Over the past three decades, multifamily rentals have consistently delivered the highest risk-adjusted returns in commercial real estate. Why? Because housing is an essential need, regardless of economic conditions. At AEG, we are strategically developing both for-sale and rental housing, allowing us to adapt our approach to changing market dynamics and maximize returns while mitigating risk. Here’s why we are confident in the strength of residential housing as an investment: Land is Finite: Unlike many other asset classes, land cannot be created or expanded. The supply is fixed, and the demand for housing continues to grow. In the foreseeable future, virtual spaces like the metaverse will not replace the fundamental human need for physical shelter. Residential Housing is Non-Discretionary, and It's Supported by Government Liquidity: Housing is the only non-discretionary asset class. If it weren’t, we would see similar government support for other sectors like retail, office, or industrial real estate, but we don't. The federal government provides liquidity to the multifamily housing market because it is a fundamental need. This support drives down the weighted average cost of capital (WACC), making housing assets attractive to investors. This consistent access to capital compresses cap rates, creating a floor on the market (to an extent), fueling long-term growth and demand from investors big and small. Rents Tract with Inflation, and It is Rare to See Negative National Rent Growth: Rents reset every year as cost increases are passed off to tenants via annual lease contract resets. Since the beginning of recorded history, national rents have only gone negative year over year three times: the Spanish flu of 1918, the Great Financial Crisis, and during the Covid-19 pandemic. While yearly gains in rental cashflow streams will not make you wealthy, they are without a doubt very stable cashflows, historically speaking. There is no similar liquidity for for-sale housing, but its non-discretionary nature still gives it a strong investment profile. In growth markets like South Carolina's tertiary cities, the influx of new residents is fueling demand across all price points, further strengthening the residential sector. We believe in our residential investment thesis for both macro and local fundamental reasons. If interest rates remain high, new construction will slow even further. Meanwhile, homes in desirable locations will remain in high demand as many homeowners—especially those with low-rate mortgages—are unlikely to sell. According to the latest third-quarter data from the FHFA, 73.3% of U.S. mortgage borrowers now have an interest rate below 5.0%, a decline of 12.2 percentage points since Q1 2022. This significant shift in mortgage rates creates a unique dynamic: many homeowners are effectively "locked in" to their current homes, preventing them from moving and creating a looser supply in the for-sale market. As a result, home prices are expected to remain elevated in high-demand areas. While values may remain relatively flat in real terms over the next few years, on a nominal basis, they are expected to rise, particularly in growing markets. If interest rates decrease or economic growth drives up rental demand, build-for-rent communities could become more viable. However, they are not yet penciling out as attractive investments because growth has stalled - but, that is about to reverse. Thanks to our strategy and access to land—often without burdening our balance sheet or stretching our resources—we are able to remain nimble and pivot towards the most attractive risk-adjusted yields. As we navigate an uncertain economic environment, several factors support the ongoing strength of the residential housing market: slow housing starts, higher interest rates, and a large percentage of homeowners sitting on mortgages with sub-4% rates. These dynamics, along with strong demand in high-growth areas, reinforce our belief that residential real estate will remain a compelling investment in the years to come. At AEG, our focus is on developing attainable, high-quality housing, from custom spec homes, to mini-farm tracts, to higher density townhome projects. This flexibility allows us to serve a wide range of income levels and tailor our strategy to market conditions. With a commitment to quality finishes and high end products, we appeal to buyers regardless of economic conditions, providing us with a tighter, more predictable cash conversion and days on market cycle, unlike some of our competitors. By seeking out individually parceled deals, we reduce overall risk and remain agile in our decision-making.
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