How Real Estate Debt Funds Work

This is a guest post by Alpha Investing, a private group of experienced investors with strong relationships with high-quality sponsors. Alpha Investing aggregates investments from its members into a syndicate and invests into sponsor projects – allowing members to access exclusive real estate projects at significantly reduced minimum investments. We have an affiliate partnership and I invest with them. Most of Alpha’s investment opportunities are common equity, but they do provide quarterly access to a commercial debt fund run by one of the oldest real estate families in NYC.

How Real Estate Debt Funds Work

Real estate debt funds help connect borrowers (often developers) with short-term capital for commercial real estate projects like multifamily buildings, shopping centers, construction loans, and many other property types. Real estate debt funds rose to prominence in the wake of the 2008 crash. Today, real estate debt funds occupy a small but profitable niche in the world of commercial real estate lending.

What is a Real Estate Debt Fund?

A real estate debt fund consists of private equity-backed capital that lends money to prospective real estate buyers or current owners of real estate assets. Investors in these funds receive periodic payments for the interest charged against loaned capital, and security charged against property assets, which takes the form of a mortgage. These funds offer loans collateralized by senior real estate assets to borrowers for a wide range of commercial and business real estate needs. 

Most debt funds are focused on a particular loan strategy or investment idea. For example, some funds will focus on offering residential construction loans to multifamily apartment builders, while others might concentrate on financing retail and shopping developments. Other common loan types include industrial, construction, hospitality/hotel, and vacant land. 

Which Borrowers Turn to Debt Funds for Capital?

Debt funds can offer commercial real estate borrowers loans and terms that traditional lenders cannot, or will not offer. They work with borrowers who have complex financial situations or do not have access to conventional credit for whatever reason. Some of the most common loan types include:

• Bridge Loans/Lease-Up Financing
• Construction Loans
• Property Rehab/Redevelopment Loans

What Sets Real Estate Debt Funds Apart

Real estate debt funds first took off in the wake of the 2008 housing crisis. At the time, traditional lenders like banks were suffering from significant liquidity issues, and commercial real estate credit dried up. Many private lenders, including real estate debt funds, stepped into this gap and began lending to commercial real estate investors and businesses. 

Although banks, agency, and Commercial Mortgage-Backed Securities (CMBS) lenders are again lending commercial capital, many traditional lenders have yet to go after borrowers in need of bridge or construction loans, leaving that sector mainly in the hands of debt funds and other private financing. Debt funds offer loans in the sweet spot where borrowers need amounts too large for small lenders and not large enough for non-bank institutional lenders, generally less than $100 million. 

"Debt funds offer loans in the sweet spot where borrowers need amounts too large for small lenders and not large enough for non-bank institutional lenders" -Alpha Investing Click To Tweet

If a business requires capital quickly, streamlined processes allow debt funds to meet their needs faster than a traditional lender. This nimbleness can be particularly beneficial in the real estate sphere, where tight closings are common and not securing funding in time can be disastrous. Owners and developers that lack the equity, or the balance sheet required by traditional lenders, or those requiring a higher loan to value (LTV) loan than a bank can offer may also turn to debt funds for financing. 

How Real Estate Debt Funds Generate Income

Real estate funds generate most of their income through interest on borrowed capital and in the case of a default, obtaining title to the collateral underlying the loan. The fund charges borrowers interest rates often starting at 9%+, which can fluctuate based on market conditions. Payments on the loan are made monthly, and rates are fixed, or priced at a 30-day LIBOR plus spread, with a floor.  Borrower fees for loans may include due diligence, origination, servicing, draw, modification, extension, or exit fees. Depending on the fund types, these non-interest-based fees may be distributed to investors in whole or in part. 

Loan amounts can range from $5 million up to $150 million or more. They offer short-term loans, for example, between 1 and 3 years. The LTC (Loan To Cost ratio) or LTV (Loan To Value ratio) for loans is dependent on location, and the specific attributes of a property- for the most part, it is not greater than 80%. 

As we mentioned earlier, in the case of default the fund may take possession of the title of the loan collateral. The fund may also look to restructure the terms of the loan with the borrower or sell the underlying note to another investor/lender. In each scenario, the lender's goal is to maximize the loans disposition value – taking into account cost and timing factors related to foreclosures and bankruptcies. With that said, the greatest upside lies in taking possession of properties that collateralize defaulted loans. Methods for increasing value differ but may include stabilizing, improving, or otherwise completing a property with the goal of achieving the highest disposition price in the shortest amount of time. 

Summary

Real Estate Debt Funds occupy an important place in the commercial real estate finance markets. The industry has helped facilitate the construction and operations of thousands of properties across the United States and lent billions of dollars to investors and developers. Their ability to move quickly and their more accessible lending criteria make it likely that real estate debt funds will continue to occupy a critical place in the real estate markets. 

Think of debt funds like the bonds of real estate vs. buying property (the stocks or equity equivalent). An accredited investor can buy into a debt fund. Keep in mind that debt fund payouts are taxed at ordinary income rates and that commercial real estate debt is not as predictable as corporate or government bonds. A great way to tax shelter this is to place your debt fund investment into a self-directed IRA. This is just a regular IRA that allows you to invest in alternative investments besides the typical stocks and bonds. The popular custodians like Vanguard and Fidelity do not offer these.