The most common type of commercial real estate investment is in the equity tranche of the capital stack. But, this isn’t the only way to gain exposure to this asset class.
In this article, commercial real estate debt investing is described. By the end, readers will know what a debt investment is, the pros and cons of pursuing this strategy, and how it compares to an investment in the equity tranche of the capital stack.
First National Partners offers equity investment opportunities in grocery store anchored retail shopping centers nationwide. However, we work with debt providers on every one of our deals. To learn more about our current real estate investing opportunities, click here.
What is Commercial Real Estate Debt?
Nearly every commercial real estate (CRE) transaction is financed with some combination of debt and equity. Debt is money that is provided by a bank or real estate lender in exchange for a promise to repay, with interest, over a certain period of time.
Although every debt transaction is unique in its own way, they typically have the following six features:
Depending on the borrower’s needs, the term for the repayment of debt could range from very short (~12 Months) to very long (~30 years).
2. Interest Rates
Depending on the type of debt provided, the loan could have a fixed interest rate or a variable interest rate that is tied to a “rate index” that changes based on certain triggers. For example, a permanent mortgage could have a fixed interest rate of 6%. Or, it could have a variable interest rate of LIBOR + 2.00%, adjusted annually.
Debt payments could consist of principal and interest, or they could be interest only. In general, longer term loan payments typically fall into the principal and interest category while shorter term loans may have interest only payments.
Debt facilities could be “fully amortizing,” which means that the final payment will reduce the loan balance to $0. Or, they can have a “split amortization,” which means that the loan term and amortization periods are different. This results in a “balloon payment” at the end of the term, which is much larger than the normal monthly payment.
Debt providers typically require the borrower to consent to a series of “loan covenants” at the time of origination. These are promises made by the borrower to the lender. For example, the lender may condition their loan approval on a liquidity covenant that states the borrower must maintain $500,000 in liquidity at all times.
Finally, the purpose of commercial real estate debt typically falls into one of three categories: purchase, refinance, or construction. The structure and approval terms vary for each. For example, a construction loan approval is typically for short term financing with interest only payments. Or, a refinance approval could be for a long term loan with principal and interest payments.
The most important point to remember about debt is that every deal is a little bit different. Loan terms are based on the lender’s risk tolerance, the borrower’s creditworthiness, and the unique features of the request. These features are important to understand when conducting due diligence on a potential debt investment and/or and formulating a debt investing strategy.
Commercial Real Estate Debt Investing: A How-To Guide
There are two ways to invest in commercial real estate debt, publicly and privately.
Public Investment Strategy
For investors who choose the public investment strategy, the most accessible way to invest in CRE debt is through the purchase of shares in a “Mortgage REIT” or “mREIT” for short. A mortgage REIT is a company that provides debt financing to commercial real estate borrowers. For example, Starwood Property Trust is a large mortgage REIT that lends money to commercial real estate borrowers or invests in debt through commercial mortgage backed securities (CMBS). When an investor purchases shares in this entity, they gain exposure to the underlying commercial real estate debt facilities. In return, they receive income based on the payments for the underlying loans.
Private Investment Strategy
If an investor chooses the private route, the most common investment vehicle is real estate debt funds offered by private equity firms. This vehicle makes loans to commercial borrowers with privately sourced capital and investors are entitled to some portion of the income produced by payments on the underlying loans. Private equity debt funds are only available to accredited investors who meet certain income and net worth requirements and it can be difficult to find a fund to invest directly in. Many debt funds cater to institutional investors like pension funds, insurance companies, and endowments. As a result, it is more likely that an individual may access debt funds through one of these types of institutions.
How Real Estate Debt Funds Make Money
A debt fund may have multiple revenue streams, but the most common (and largest) is likely to be through the “spread” on the difference between their cost of capital and the interest charged on their loans. To illustrate this point, an example is helpful.
To fund their lending activity, debt funds need to source capital from investors, both individual and institutional, and it comes at a price. They may have to provide guarantees that they will pay a certain rate of interest, this is known as their “cost of capital.” For example, suppose a fund sources capital from a variety of investors with an average cost of 4.25%. Then, the fund turns around and lends this money to borrowers for their commercial real estate projects and charges them interest for this privilege. Suppose the same fund receives an average interest rate of 7.25%. The difference between the interest earned (7.25%) and the cost of capital (4.25%) is known as the “net interest margin” and it is how private lenders make money.
To put this point in perspective, the net interest margin can be multiplied by the total amount of outstanding debt as a general rule of thumb for revenue. A 3% interest margin on a $1B portfolio of loans would produce $30M in revenue.
It should be noted that there are many different types of debt, all of which have a different risk/return profile. For the purposes of this discussion, the pros and cons of an investment in “senior debt” are described below.
Pros and Cons of a Real Estate Debt Investment
In general, a debt investment is considered to be “safer” than an equity investment for the following four reasons:
- Repayment Priority: Senior debt investors are first in line to be repaid. If the property and loan performs as expected, this can be a relative non-issue, but this distinction can be particularly important in the event of a bankruptcy or foreclosure. When a property is sold, senior debt investors get paid first.
- Collateral: Senior debt is secured by a first position lien on a commercial property, which provides the senior lender with the ability to initiate foreclosure proceedings. In the event of default, they can initiate this process, take possession of the property, and sell it to repay themselves.
- Income: As part of their loan agreement, borrowers are required to make regular payments on their debt. These payments can produce a steady stream of income for investors.
- Diversification: Debt funds make many loans to many borrowers in many markets. This provides debt investors with a high level of diversification to offset non-performance in any one facility.
While debt investments have a degree of relative safety, there are still a number of risk factors that potential investors should consider.
The potential risks of a debt investment include:
- Default: Things do not always go according to plan for borrowers. When they don’t, a borrower could default on their loan, which means they have broken the terms of the loan agreement. The most common type of default is when the borrower stops making their loan payments and this can trigger a string of adverse events that pose risks to debt investors.
- Interest Rates: Interest rates are constantly changing. If lenders have a high number of variable rate loans on their balance sheet, they could be vulnerable to interest rate declines, which means less interest income.
- Property Types: Certain types of commercial properties are riskier than others. For example, multifamily and grocery store anchored retail centers tend to be less risky while hotels, restaurants, and raw land tend to be more risky. So, it is important to understand the composition of a debt fund’s underlying portfolio to fully assess the risk. A portfolio of hotel loans could be far more volatile than a portfolio of multifamily loans.
Potential debt investors should always perform a significant amount of due diligence on the types of loans and the process that a fund manager used to make them to ensure they are comfortable with the investment’s risk profile.
How Does Debt Investing Compare to Equity Investing
There are two key differences between a debt investment and the types of equity investments that we offer to our clients.
First, is the repayment priority. In the bullet points above, it was mentioned that debt investors are first in line to be repaid, and they are. But, equity investors are only paid after debt investors. This means that the equity position carries more risk, but can also come with higher returns to compensate.
Second, equity investors participate in capital gains on the sale of the property. Debt investors do not. For example, if a property is purchased for $5,000,000 and sold for $10,000,000, there is a $5,000,000 gain which equity investors are entitled to their pro rata share of. This can result in higher overall returns.
Conclusions & Summary
Commercial real estate debt is money that is provided to purchase, refinance, or construct commercial real estate assets. Each deal is unique and tailored to the needs of the borrower.
For investors interested in commercial real estate debt investing, there are public and private options. With the public route, investors can buy shares in lenders directly or in a mortgage real estate investment trust. With the private option, investors can turn to private equity firms who offer debt funds.
There are a number of potential benefits to a debt investment including its repayment priority, relative stability, and interest income. But, these should be considered within the context of risks, which include things like default and changing interest rates.
There are two key differences between debt investing and equity investing. Equity investors only get paid after debt holders, but they have an opportunity to participate in gains on the sale of a property.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.