Over the past few years, particularly with the onset of the global COVID pandemic, the commercial real estate market has experienced both ups and downs — from expansion in sectors such as industrial and life sciences to turbulence in office and some areas of multifamily. Now, a period of rapid interest rate increases and the recent collapses of Silicon Valley Bank, Signature Bank and First Republic Bank have created a significant liquidity gap in the commercial real estate market.

In the wake of these bank failures, many consumers are pulling out of smaller banks and betting their money is safer in the largest banks. The deposit outflow has created mounting concerns for regional bank lenders, and the influx has left many of the largest banks with the opposite but equally complex issue of having a surplus of cash and the need to invest it.

Traditional lenders such as banks and life insurance companies have faced increased scrutiny and increasingly stringent leverage constraints for many years and are now further constrained as they are pushed to increase reserves by regulators. Nevertheless, property owners’ capital needs can extend beyond the levels that traditional lenders can meet. This is where private and nontraditional lenders play a role. They have the capability to provide additional capital via mezzanine or preferred equity investments, creating a tier of private real estate debt in a property’s capital structure that sits between the senior mortgage and the property owner’s equity.

Mezzanine and preferred equity structures can appeal to both senior lenders and property owners. Senior lenders such as banks and life insurance companies are not typically in the business of owning and operating real estate, and the presence of an experienced investor in the subordinate debt position can provide additional subordination and a potential owner in the event of default. Property owners, on the other hand, may prefer to borrow more money rather than investing additional equity when the blended cost of additional financing versus contributing more equity is accretive to equity returns and limits equity dilution.

From an investor’s perspective, mezzanine and preferred equity investments have the potential to create value for investors during times when high interest rates make it difficult to find attractive risk-adjusted return opportunities on the private equity side — and the opportunity can be accessed by retail and institutional investors alike through a wide variety of investment vehicles.

In addition to potentially attractive income returns, private debt investments have historically exhibited low correlation with other debt and fixed-income investments, enhancing diversification within a portfolio. In comparison with core real estate equity investments, they have been historically less reactive to declines in asset values and have produced income yields above distributable cash-flow yields produced by properties over comparable time periods.

In the face of rising rates and uncertainty in the banking sector, nonbank lenders have the potential to fill the critical financing gap so many senior lenders, property owners and investors are seeking, while providing opportunities to both institutional and retail investors.

Drew Fung is managing director of Clarion Partners.