Real Estate Credit vs. Corporate Credit: Understanding the Distinctions

Introduction

Investors in credit will want to look at both loans backed by real estate and loans backed by companies. Real estate credit refers to loans or financing provided for purchasing, constructing, or refinancing property, such as residential, commercial, or industrial real estate. Corporate credit, on the other hand, involves financing granted to businesses to support their operations, growth, or investments, often in the form of term loans, lines of credit, or bonds. Rising interest rates have affected real estate and corporate credit differently. Comparing the markets for these two forms of credit helps investors evaluate their distinct roles in the economy, assess risk profiles, and understand how they cater to different financial needs—individuals and entities in real estate transactions versus corporations seeking capital for business endeavors. Such comparisons are vital for investors, lenders, and policymakers to allocate resources effectively and manage credit portfolios strategically.

Real Estate Credit

Real estate credit is characterized by several features that distinguish it from other forms of credit. One key characteristic is the use of collateral, as these loans are secured by real property. Terms for real estate credit vary, providing borrowers with a menu of repayment periods. Interest rates for these loans can be either fixed or variable, depending on the agreement between the lender and the borrower. The repayment structures can vary as well, ranging from amortizing loans, where borrowers make regular payments to reduce the principal over time, to interest-only loans, where borrowers initially pay only the interest.

Additionally, and importantly, real estate credit secured by residential property is often backed by government-sponsored entities such as Freddie Mac and Fannie Mae, which provides added security and stability to the financial market. The tangible nature of the collateral, along with standardized valuation methods, generally makes it easier to underwrite real estate loans. These attributes contribute to the ability of investors to evaluate real estate credit in the financial landscape and manage their financial transactions with a degree of certainty and safety.

Risk Factors

Several risk factors are inherent in real estate credit. One of the primary risks is the fluctuation in property values. When property values decline, the collateral securing the loan diminishes in worth, increasing the lender’s risk. Another significant risk factor is the borrower’s creditworthiness, which can affect their ability to make regular mortgage payments. Economic conditions also play a crucial role; a downturn can lead to higher default rates as borrowers face financial hardships. These potential risks require careful management by lenders to ensure that their real estate credit portfolios remain resilient and secure.

Corporate Credit

Corporate credit, on the other hand, serves a different set of financial needs. Defined as loans provided to businesses for various purposes, corporate credit is utilized for working capital, expansion, acquisitions, and other corporate needs. Types of corporate credit include term loans, revolving credit lines, business credit cards, and trade credit.

Term loans are commonly used for substantial investments or significant capital expenditures, providing businesses with a lump sum that they repay over a specified period. Revolving credit lines offer flexible borrowing options, allowing companies to draw on funds as needed and repay them, like a credit card, which makes them ideal for managing cash flow. Business credit cards provide an additional means of financing day-to-day operations and expenses, offering the convenience of immediate access to credit. Trade credit, on the other hand, allows businesses to purchase goods or services on account, deferring payment to a later date, which can be critical for maintaining liquidity.

Corporate credit can be either secured or unsecured, depending on the nature of the loan and the borrower’s credit profile. This difference is also reflected in the interest rates, as corporate loans might have higher rates compared to real estate loans, due to the increased risk and lack of tangible collateral. Furthermore, the repayment structures for corporate credit can vary significantly. Some loans may require bullet payments, where the entire principal is repaid at the end of the term, while others may follow more traditional installment plans. These varied characteristics underline the flexibility and adaptability of corporate credit in meeting the diverse financial needs of businesses.

The variety of loan structures and credit can present an underwriting challenge for investors. Businesses appear in many forms and corporate credit plays a vital role in ensuring the financial resources necessary to operate effectively, grow, and seize new opportunities. Whether it’s through structured term loans, flexible revolving credit, convenient business credit cards, or practical trade credit, corporate credit appears in a wide variety of in support of enterprises of all shapes and sizes.

Risk Factors

Business performance and financial health, industry risks, and economic conditions all play pivotal roles in determining the viability and security of corporate credit. Investors should understand which companies possess strong financial health and robust business performance required to meet credit obligations. Conversely, businesses operating within volatile or declining industries may face higher default risks due to factors beyond their control. Additionally, broader economic conditions can significantly impact corporate credit markets in different ways; an economic downturn can elevate default rates, while a booming economy may enhance businesses’ repayment capacities.

Understanding these variables is crucial for investors as they navigate the complexities of corporate credit. Achieving this understanding is critical in distinguishing between safer and riskier credit opportunities, ultimately guiding more informed and strategic financial decisions.

Current Opportunities

Corporate credit markets are experiencing growth due to low interest rates and investor demand for higher yields compared to government bonds and corporate debt burdens are unusually high.¹ Banks had been ceding ground on private debt due to regulatory restrictions, making them less likely to make and hold risky loans.² Fewer banks in the market have created opportunities for alternative lenders to step in and seize market share.¹ These funds, managed by global and regional asset managers, lend directly to businesses, offering financing options that may not be available through traditional banks.¹

Businesses have taken advantage of favorable borrowing conditions to finance expansion, acquisitions, and other strategic moves, but some are now struggling as rates have risen above 5%.¹ Rising rates have increased the cost of servicing their debt, consuming large portions of their cash flow and forcing some to rely on payment-in-kind (PIK) loans to defer payments.

Potential Bubble

Red flags are emerging in parts of the $1.7 trillion private credit market with an expectation for more private fund and business development companies to face increasing performance challenges.²

Warning signals are emerging as borrowers contend with the realities of potentially higher-for-longer interest rates, according to a Moody’s report earlier this year that cited an increasing number of PIK loans.² “The increasing number of PIK (payment in kind) loans and nonaccruals is a red flag because it suggests that … borrowers are experiencing weakening cashflows.”² When interest rates were low, businesses could more easily manage their debt burdens. PIK loans temporarily ease cash flow issues but result in higher overall debt levels, creating long- term challenges for these companies, even as the general economy continues to expand.¹

Ultimately, vulnerabilities are appearing in corporate credit, particularly for businesses that relied heavily on borrowing during the low-rate era. If economic conditions deteriorate or interest rates rise sharply, businesses may struggle to service their debt, leading to higher default rates and potential market instability. Investors should be cautious and assess the creditworthiness of issuers carefully to mitigate potential risks.

Real Estate Credit

Rising interest rates plays out differently in real estate credit, along with investors’ ability to underwrite the opportunity. Compared to corporate credit, real estate loans are made in far fewer structures. As discussed above, term, fixed or floating rate and amortizing or interest-only structures fill the bulk of the variables. Also, unlike corporate credit which requires investors to underwrite many businesses, real estate credit requires only one, real estate. And, real estate credit secured by residential property is often backed by government- sponsored entities such as Freddie Mac and Fannie Mae, which provide added security and stability to the financial market.

Like corporate credit, banks have pulled back from real estate lending. Increasingly, owners are turning to the private real estate debt market as banks continue to tighten their lending requirements, putting private real estate debt managers in a position to capture that business.³

As a result, as of the third quarter of 2024, real estate credit led all real estate segments in growth over the previous 12 months, with investors increasing their target allocations to real estate credit.³ One area of growth is development lending. Development activity is down as banks are pulling back from making construction loans creating an opportunity to lend to builders delivering assets into a more supply constrained environment.¹

Conclusion

Corporate and real estate credit investment opportunities have both grown as banks have pulled back. However, in the corporate credit universe, some businesses that leveraged favorable borrowing conditions for expansion and acquisitions are now struggling with debt as interest rates surpass 5%, leading to increased costs and reliance on payment-in-kind loans. Vulnerabilities in the private credit market are becoming evident, with rising rates and weakening cash flows signaling potential defaults and market instability. Conversely, the real estate credit market has shown growth, particularly in development lending, as banks retract from real estate lending, allowing private debt managers to capitalize on the opportunity. Investors must carefully assess the creditworthiness of issuers in both corporate and real estate credit to mitigate risks.

Important Disclosures

¹ Source: Financial Times; “Corporate debts mount as credit funds let borrowers defer payments”, October 13, 2024.
² Source: Pensions & Investments; “Red flags rising in private credit market – Moody’s Ratings”, May 7, 2024.
³ Source: Pensions & Investments; “Real estate credit strategies – the lone bright spot for the year”, October 7, 2024.