What is Real Estate Debt Fund Investing

Private real estate debt funds were born, for the most part, out of the aftermath of the financial crisis. During 2009 — 2010, while banks remained paralyzed and failed to provide any sort of debt liquidity, private lenders began to emerge to fill a market void. Private lending has grown every year since and is now a major industry. According to Preqin, an institutional research firm, institutional private debt funds secured $85.2 billion of global commitments with $49.6 billion of that total in North America. Private debt funds are also popular with investors. At the end of 2015, 86% of investors polled by Preqin were satisfied with the returns generated by private debt funds and 46% of those polled plan to increase private debt allocations in 2016.

Private real estate debt funds have multiple strategies, currently, the most popular one is direct lending, or loans made by private lenders directly to borrowers. Within direct lending, real estate is the most popular type of collateral. For the purposes of this article, we will focus on real estate direct lending funds and provide some key points to better understand how these funds work, how to assess risk vs. reward and explore their fit in a diversified real estate portfolio.

What are real estate direct lending funds?

Real estate direct lending funds are pools of private equity-backed capital that have mandates or objectives to originate senior real estate collateralized loans for qualified borrowers. Generally, most are structured to execute a specific loan strategy or investment thesis. Take for example, Trueline Capital Fund II, a private direct lending fund currently offered on the Crowd Street Marketplace. Trueline Capital Fund II originates residential construction loans to single family home builders throughout the Pacific Northwest that are collateralized by first deeds of trust on the properties undergoing development. As a means to mitigate risk and manage its capital exposure, it funds its loans in tranches as construction occurs.

How does debt differ from equity?

Debt investing is vastly different than equity investing. Debt investing focuses on mitigating risk at every turn in order to maximize the probability of earning a fixed rate of return and collecting specified fees. Conversely, equity investing seeks multiple avenues of potential upside to compensate for the downside risk of losing the entire investment amount to a debt holder. The critical distinction is that the debt investment '“ the underlying loan '“ is backed by a hard asset as collateral, and not just a business plan of what someone hopes to achieve. In addition, by lending only up to a certain percentage of the initial value of the hard asset, the integrity of the debt investment is insulated from asset value declines up to the full amount of pledged equity.

How do direct lending funds make money?

Direct lending funds make money on the interest rate or lending rate they charge over the course of a loan. They also charge fees over the life cycle of the loan, which may include origination fees, exit fees, early termination fees and extension fees. Investors have the ability to participate in all of those fees, in addition to the interest coupon, as a return on their principal investment. Those returns are given to investors as ordinary income distributions for tax purposes.

Why the borrower demand?

From an outside perspective, it can appear that real estate lending is a commoditized space with myriad players including banks, life insurance companies, CMBS and government agencies such as Fannie Mae and Freddie Mac. However, financing is not a one-size-fits-all solution. Direct lending funds fill market gaps by bringing efficiency, speed to market or understanding to unique market opportunities. They often operate in niches where traditional banking vacated the market in 2008 and, in some cases, never returned.

In addition, when you deconstruct various lenders, it's a mixed bag. Life companies, for example, have a reputation for focusing on conservative loans for stable commercial and multifamily real estate in major metros. In most cases, they don't like to venture too far outside of that comfort zone. Banks can lend on both new construction as well as stabilized assets, but the process can be onerous and slow-moving with more hoops to jump through due to the tighter regulatory environment. Direct lending funds can be fast and nimble, and that is an attractive feature for borrowers who may need to move quickly on a new development or acquisition opportunity. This nimbleness comes at a price, which benefits debt funds and, in turn, investors.

What is the downside risk?

Much like any investment, real estate debt funds are not without risk. The private capital nature of direct lending funds grants them much greater latitude in lending decisions in comparison to banks. To mitigate downside risk, fund managers will seek to solve through structure. For example, you will typically see lower loan to value ratios from private debt funds vs. banks for similar loans, which means the borrower is risking more capital loss prior to first dollar loss to the lender. Lenders refer to this practice as 'asset-based lending'. Specific to construction loans, the fund manager has the ability to manage debt reserves as a means to mitigate risk. Construction loans are not paid out in one increment, but rather in a series payments that are issued over time as a project progresses through its development.

Lending does have default rates in good and bad markets. After reaching a peak default rate of 10.02% during first quarter 2010, the average real estate loan default for both residential and commercial loans has dropped back to 3.27% as of fourth-quarter 2015, according to the Federal Reserve. As noted above, the larger the pool of loans the better able debt fund managers are to anticipate default ratios and price it into loans accordingly.

Why invest in direct lending funds?

There are three primary reasons to invest in direct lending funds:

1. Steady current income: One of the big selling points for direct lending funds is that they deliver 'mailbox money' a steady, high-yielding income to investors, typically on a monthly basis. In a yield starved investment climate, monthly distributions that can average around 8% on an annualized basis can look highly attractive.

2. Security in the capital stack: As mentioned above, by issuing senior debt, direct lending funds take priority to other forms of financing such as mezzanine loans, preferred equity or equity. When assembling a real estate investment portfolio, allocating a portion of investable dollars to an income-oriented product that is senior to all other positions in a capital stack is an excellent diversification tool.

3. Diversification: Allocating capital across as large a pool of loans as possible optimizes predictability in loan performance and, hence, mitigates single loan risk exposure.

Direct lending returns vary depending on the individual offering. However, many direct lending funds target annualized net-to-investor returns of 10% -12%, which compares favorably to other alternatives such as corporate bonds and even equities in the current market.