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Private credit debt has grown substantially into a diverse trillion-dollar marketplace that is steadily becoming more mainstream and accessible. Newer opportunities for income investors are opening up from outside of the traditional lending channels as many larger banking and financial institutions cannot play in some of these smaller, burgeoning niche credit markets. While smaller in size, there is still a lot of business to be done in these niche markets, like in Commercial Real Estate (CRE) short-term lending which is now a $600-$700B market and creating a great deal of opportunity for boutique investment firms and alternative income investors.
To learn more about this specialized private credit market, we were introduced to Zach Murphy, Chief Investment Officer of Pender Capital - a vertically integrated investment firm dedicated to CRE credit-based investments that has originated over $1 billion in commercial real estate loans and manages the Pender Capital Real Estate Credit Fund (PNDIX), a continuously offered closed-end, interval fund that seeks to offer investors access to the once restricted commercial real estate debt asset class.
Hortz: Can you provide us your brief perspective on the U.S. Commercial Real Estate Credit market and where your investment firm is positioned within this area?
Murphy: We are on a down trend in this current commercial real estate cycle and the biggest thing you can say about it now is that it is a very tentative market. Despite this, there is substantial capital that is interested in being in a secured position in the capital stack, so commercial real estate credit is definitely still in vogue from that capital market standpoint. The dislocation of capital due to the tightening of credit, the more conservative ways that people are looking at this space, and the overall dearth of quality has put our decade-long credit origination and underwriting platform in a particularly good position. We have seen a lot of paper and niche opportunities among many of these challenged credit requests over the last 18 months to two years when the market turned, so we already had a leg up in sifting through them and positioning ourselves to quickly find the right credit opportunities that can provide valuable benefits to income investors.
We focus our lending efforts in the middle market, real estate credit arena providing short-term, one-to-three-year loans for commercial real estate developers and sponsors that are primarily looking for turnaround opportunities in today's commercial real estate market. This is where they find a property where there is a potential reset in value; where a property can be acquired at a good discount to where values have been or would trade in today's market. That discount has to do with either some particular timing issues or some distress where the seller or the property is and our borrowers are coming in wanting to capitalize on that distress and see an upside in acquiring the property and executing a business plan to improve or restabilize it.
With our Pender Capital lending platform and short-term bridge loans, we take them from property acquisition, through their typically one-to-three-year business plan, and then take the property back to the market for either a recapitalization or a sale where they can capitalize on the improvements that they have made on that property.
Hortz: Since you originate and service senior position short-term loans in this CRE market, why do you characterize what you do as developing forward-thinking lending solutions that capitalize on commercial market inefficiencies?
Murphy: Let me break that question down into a couple of different sections. When we say we are lending by using forward thinking and looking forward, we are. But to be clear, it is not very long-term forward. It is looking forward a year to three years down the road - through the life of the loan and the real estate project it is funding. We are looking down the road to determine if this loan is backed by a well-thought-out business plan. We are coming into that senior credit position or senior secured position with a large chunk of equity capital that is investing in the real estate project to add value to the property through renovations, capital improvements, tenant improvements, and so forth. The things that are going to make that property more valuable or where they can get a certain amount of rent which is more than they are getting today. We are really underwriting that business plan if it has a very solid and fundamentally sound real estate strategy.
The other part of that statement has to do with the dislocation in the middle market in commercial real estate credit. When you get into large commercial transactions and the upper echelon in terms of size of loans, there is a very well-defined market for large long-term commercial real estate credit and the players are well-defined; the names are household names if you are in the market to borrow $100 million or more. But, particularly in the middle market where we are talking about real estate deals that are $10 million to $20 million, that market is much less efficient and is much less defined as it relates to who the players are. If you are in let us say, Oklahoma City or Nashville or Tucson, AZ, and you need a short term $12 million loan for two years, it may not be as clear as to who are the reliable sources of capital that you can go to and get that type of financing. Pender has helped on a nationwide basis to fill some of those gaps.
Hortz: How do these middle market inefficiencies help position you to take advantage of investment opportunities for your investors?
Murphy: As we discussed, there is this window of lending opportunity – being too large for local lenders and too small for national lenders. That niche really plays well into the Pender lending platform which focuses on that underserved part of the market as we are able to offer great funding solutions for those real estate borrowers and underwrite quality deals at favorable yields from a strong risk-adjusted standpoint for our investors.
We have been doing this for almost a decade and have established a great reputation in this middle market real estate credit market as a reliable lender who will do what they say they will do, who can close in time, and helps to stabilize some of those mid-tier transactions and real estate markets.
Hortz: Can you further discuss how your underwriting process for these loans is different from how banks or other financial institutions and any further benefits it may provide?
Murphy: As we discussed previously, the biggest differentiation from standard underwriting practices is from the standpoint of how we look at a loan opportunity - we really are forward-thinking and forward-looking. We do not just look at how the property has performed over the last few years like a conventional bank underwriter would. We are looking at the opportunity of what the loan is going to be used for and if it is for the best use of the property. We also question whether this is the right sponsor to execute that “best opportunity” business plan? We look at the risk of the deal and the business plan. We then look at each loan as if this is our money and are evaluating and watching over this deal as if we are investing only our own personal money and that brings quite a different perspective to every transaction.
Because it is a short-term loan on our books and we understand the developer’s business strategy, there is less risk for us versus a traditional CRE loan. The typical real estate business cycle and loan is on average 10 to 15 years. The advantage for us being in the shorter-term duration lending space rather than having to put out a 10-year note, is that it allows us not to have to play in these long-term cycles and take the risk of that full cycle – that means getting in on at the top of the real estate loan cycle and having the weather the storm of going to the bottom of the cycle while our paper is maturing. Not having to underwrite for an entire cycle in the real estate market is a real advantage.
The other advantage is because we are not writing long-term paper, we do not have to commit capital for the entirety of a potential cycle and that enables our sponsors to lift the value of the property in a short period of time. Our window of that cycle is truly short and we are able to recycle the risk and recycle the capital around every two to three years funding new strategic real estate projects.
Hortz: Working across the country as you do, how do you find these deals or do most of them come to you?
Murphy: Yes, most of them do come to us. Having established a strong reputation over the last decade has helped to create a consistent deal flow for us. We also work well with other conventional lenders and get a large portion of our business from banks, insurance companies, and large institutions that do not specialize in short-term financing but they want to help provide a good source of capital for their customers that they cannot serve in this area. Then we also work with financial intermediaries, mortgage brokers, real estate agents, CPAs, and attorneys which also are very good sources of business for us. We have become known as a source of reliable capital.
We can and will lend in all 50 states but generally our focus is in secondary markets. We do not do a lot in the top five or six markets in the country just because the competition in those markets is so steep. And as you know, competition makes capital more efficient and cheaper and that is not something that fits well in our focus of getting the best risk-adjusted yield we can for our investors. We tend to be in the next 20 or 25 state markets like Phoenix, Dallas, Nashville, Tampa.
Hortz: Why did you choose a closed-end interval fund structure for your investment vehicle? Are there any particular benefits to this vehicle for your investment strategy and investors?
Murphy: There were a few advantages that we saw right off the bat. One is the public nature of the fund and ready access it provides for retail investors at a smaller investment minimum than the traditional large institutional minimums. Also, the interval structure provides for regular investing as a continuously offered fund with quarterly liquidity options in a real estate credit investment class that has historically been incredibly illiquid and had to be locked up for multiple years.
The interval fund structure from an investment management basis, I think also gives us a leg up in being laser-focused on our loan portfolio and what is going on in our markets without having to meet immediate day-to-day redemptions. It blends a little bit of the benefit of having some liquidity for the investors, but also having a structure through the interval fund that allows us to invest in something that is a relatively illiquid investment.
Hortz: Any thoughts for advisors and asset allocators on how to best position this investment strategy and its risk/reward profile in their client portfolios?
Murphy: This fund definitely fits in a few investment buckets, particularly in the alternative income bucket. It provides a healthy yield that we distribute on a monthly basis to our investors that you might not expect from something that is essentially illiquid, except for the quarterly opportunities as needed. It also has the benefits of a broad base of commercial real estate exposure without having a significant concentration because of the deal sizes.
This investment strategy diversifies income investors into a unique niche in the private credit real estate market that is actively involved in helping real estate companies raise needed capital in quality real estate projects versus a traditional strategy of just being a passive bond or credit vehicle investor.
One of the things that further benefits investors is the number of transactions and opportunities that we see. Year-over-year, we will see upwards of $10 billion of loan opportunities we could underwrite. We have the ability to utilize negative selection and underwrite the best quality loans with strong risk-adjusted returns for our investors. That is a strong advantage for our investors.
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