An Investor’s Guide to Real Estate Debt Funds
Real estate debt funds first emerged in the wake of the 2008 financial crisis, providing an efficient way to connect lenders with developers needing short-term capital for a range of commercial real estate projects. Following the crisis, traditional lenders tightened regulations and liquidity requirements for borrowers. Banks were resistant to offering loans for commercial real estate and, if they did offer loans, they placed greater focus on income and cash flow than on equity and assets. Real estate debt funds were able to service a small but potentially very profitable niche market.
What exactly are real estate debt funds?
- Private, equity-based capital lending money to prospective or current owners of real estate assets
- Funds providing loans collateralized by real estate assets to borrowers for a range of commercial, business, and real-estate development
- Funds offering investors regular payments based on interest charged on commercial real estate loans
- Real estate debt funds provide a pooled investment, opening opportunities for individual investors to benefit from fixed-income returns from commercial real estate
- Funds may offer short-term loans (one to three years) with amounts ranging from $5 million to $150 million+
- In 2015, the five largest funds were responsible for $101.8 billion, or 55% of capital raised in that year
Funds may choose to focus on one particular type of investment; e.g., apartment buildings, shopping centers, or industrial development.
What kind of borrower can benefit from real estate debt funds?
These funds cater to borrowers who:
- Would not qualify (for a number of reasons) for more traditional loans
- Require better terms than are available through banks and other traditional lenders
- Need short-term bridge loans
- Need rapid loan approvals to enable them to meet tight closing deadlines
- Need loans for commercial construction or redevelopment
- Require a higher loan-to-value ratio than traditional lenders would agree to under the tighter regulations
Despite the fact that in recent years traditional lenders have begun to reconsider their commercial real estate lending practices, many still do not provide bridge finance or construction loans.
Debt Investment Benefits for Investors:
- Interest rates vary considerably and investing in a real estate debt fund means that investors receive an average interest rate on their investment (not dissimilar to mutual funds.) Interest paid is usually in excess of 9%, offering steady income with a low-risk threshold
- Loans made by the funds are often short term, and – in the event of a default – the fund will obtain title to the collateral provided
- Real estate debt investments offer individual investors the chance to access a highly lucrative market
Every potential investor is searching for the same elusive magic formula: low-risk plus high returns. However, that is not how most investments work – generally, the higher the possible return, the higher the risk, and vice versa. Arguably, real estate debt funds can defy this rule of thumb, making them very attractive to investors.
The Capital Stack exemplifies how debt funds compete for investors and demonstrates priorities for repayment.
Image credit: Sharestates.com – “Filling the capital stack”
As can be seen from the above diagram, there are four major tiers.
- Senior debt: Debt investment takes priority over equity investments; within debt investment, senior debt is the primary lender and has the first right of returns; senior debt must be paid off before equity investors receive any returns.
- Junior debt: Junior debt, or “mezzanine debt,” is the secondary lender for real estate loans. As such, it is riskier than senior debt but attracts higher rates of interest, along with stricter terms.
- Preferred equity: Equity investors only start to receive returns after all debt has been paid off; preferred equity has the higher priority.
- Common equity: As with junior debt, common equity has a lower priority than preferred equity – it is therefore riskier, albeit with higher returns
By using the capital stack, debt fund managers can offer competitive opportunities for investors in a number of ways:
- Diversifying the different types of debt within a real estate fund so that investor risk is mitigated
- Focusing on the lowest risk categories – and diversifying within the senior debt category – having priority over any other debt and equity investment means that, even with lower risk, reliably decent returns can be realized
- Focusing on short-term debt opportunities that show higher returns on a regular basis
In this way, real estate debt funds have offered better opportunities to investors while also mitigating risk. The capital stack can be used as a way to build an investment portfolio that can lead to the elusive high-return, low-risk formula.
What does the future hold for real estate debt funds?
Real estate debt funds gained popularity in the wake of the 2008 crisis; what is likely to happen to them as a result of the current pandemic? In his blog, CEO and co-founder of Sharestates
Allen Shayanfekr writes:
“COVID-19 is proving to be a unique opportunity for some distressed real estate fund investors, but it could prove to be a pitfall for others… According to Business Insider, more than $10 billion is about to pour into the real estate sector through distressed debt instruments.”
Without a crystal ball, the long-term effects of the COVID-19 crisis cannot be accurately foreseen; nonetheless, it is not too far-fetched to assume that the current situation will result in ongoing opportunities for investors through private real estate loans.
If you’re interested in learning more about real estate debt funds and how you can increase your returns on investments with less risk, contact our Titan Funding team.