As interest rates rise, the dollar strengthens, trade wars mount and heightened volatility across markets persists, institutional investors are adjusting their risk profiles and shifting dramatically toward debt investments. As part of this shift, investors are now piling capital into private debt in an attempt to protect themselves from an expected market correction while still earning stable returns. According to Preqin, private debt funds raised a record $107 billion last year. Fundraising through the first half of 2018 remains robust.

With such volume of capital flowing into private debt, it can be challenging to find value. One private debt sector that may be especially attractive to institutional investors is commercial real estate (CRE), which offers the potential for both diversification and an attractive risk-return profile at this late stage of a nearly decade-long bull run. With more than two decades of experience in this sector and as a commercial real estate direct lender, I’ve seen firsthand how CRE private debt can be a useful addition to diversify a portfolio with assets uncorrelated to equity markets. Although CRE prices linger around all-time highs, the healthy U.S. economy and favorable tax policy mean there are still ample opportunities to get exposure to an attractive asset class.

Risks Rise Across Markets With Interest Rate Shift

Many signs are beginning to point to a peak in the market, with investors beginning to look for cover. Since 2015 the Fed has been lifting its key policy rate from historic lows, elevating interest rates and bringing a period of loose monetary policy and easy credit to an end. Though rising, bond yields remain low, and most returns on higher-rated debt securities remain relatively modest. Risks rise as the credit cycle turns, so investors are prudent to shift allocations from volatile equities to more secure fixed-income instruments.

Institutions looking to invest in CRE can typically choose between equity and debt vehicles, each of which comes with its advantages and disadvantages depending on where we are in the cycle. Early in the cycle, as CRE property values rise, allocating more toward equity instruments makes sense. Here, investors can buy property outright or purchase stock in firms that specialize in CRE. They can also invest in mutual funds or exchange-traded funds that provide equity exposure to CRE.

As prices peak, CRE debt vehicles can present a more secure option, and an attractive middle ground between volatile stocks and zero-interest savings accounts, efficiently balancing risk and returns while providing consistent cash flow to a portfolio. Many CRE debt instruments offer the added benefit of short-term duration, allowing institutions to “roll up” the yield curve as rates rise.

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