This article takes a closer look at real estate debt investing, and how it can complement both an equity-based real estate portfolio and a more traditional fixed income portfolio.
Intro: What is Commercial Real Estate (CRE) Debt
Traditional investment advice states that, as you approach retirement, your overall investment mix should weigh toward wealth preservation and risk mitigation. High-return investments tend to capture the bulk of media attention, as risk and outperformance make for a more dramatic narrative. From cryptocurrencies to pre-IPO startups to untested technology, exotic investments with the potential for significant upside make for an exciting story.
By contrast, more conservative fixed-income assets are generally viewed in a less enthusiastic light; much like visiting the dentist, allocating to such assets is a thing you know you should do for long-term health, but is not necessarily exciting. Private CRE debt offerings on the EquityMultiple platform offer a hybrid profile—predictable cash flow, relatively short target duration, and a higher target return than many fixed income alternatives in the public market.
Private real estate debt investing provides the additional benefit of seniority/payment priority to the other investment capital and the security of an underlying commercial property.
Real Estate Debt Investing—A Brief Historical Perspective
As of this writing, the decade-long economic recovery has been characterized by low interest rates and as a result limited high-yielding, fixed-income investment options. From CDs to treasury bonds to unit investment trusts to utility stocks to fixed annuities, these options offer relatively low risk and require very little upkeep, but are often limited to low single-digit returns. Commercial mortgages have and continue to trade at a premium to other asset classes. Similarly, EquityMultiple’s senior debt investments target annual returns in the high single to low double digits for terms ranging from six to sixty months.
EquityMultiple investors often participate pari passu with other highly experienced private lenders and benefit from strong rights and remedies in downside situations. EquityMultiple conducts extensive due diligence on co-lenders, borrowers, and the underlying real estate securing the loan, and offers participation in its real estate debt investment offerings for minimums as low as $10,000. There are numerous reasons why a borrower will opt for a private lender rather than a bank, including the speed to closing/funding, prepayment flexibility, and overall ability to structure a loan to best suit a project’s needs. This private loan market is generally closed to individual investors, but EquityMultiple makes investing in these attractive risk-adjusted CRE loans simple and accessible.
The Risk/Return Profile
Return potential is always a function of risk. Commercial real estate debt is no exception and it is certainly not comparable to the safety of investing in US treasury securities or certificates of deposit (CDs). However, there are a few key ways in which CRE debt investments, like those on our platform, benefit from collateral enhancement and downside protection:
- Collateralization—These loans are secured by real property, typically through a mortgage or deed of trust. The lender may take control of a property in the event that a borrower defaults. In order to avoid these scenarios, EquityMultiple performs extensive credit (property) underwriting and only extends loans to experienced borrowers with good credit history. The ability to ultimately take over and sell a property to recover our investors’ capital provides substantial downside protection.
- Conservative Leverage—Most lenders require the borrower (or “sponsor”) to contribute a certain percentage of their own capital to a real estate project, much like a bank issuing a residential mortgage would require a down payment. EquityMultiple typically targets loans with a loan-to-value (LTV) of 75% or lower. This serves two purposes: 1) ensuring that a borrower has “skin in the game” and aligning the interest of both lender and sponsor for the success of the property while incenting a borrower to make timely interest and principal payments; and 2) providing a cushion for the lender (and thus EquityMultiple’s investors) to recover its investment if a property declines in value, particularly in the event that a sale or foreclosure is necessary.
- Lending Partner Experience—When investing with EquityMultiple in CRE debt investments, you may also be investing next to, senior to, or junior to other lenders. That partner’s experience and track record is key. In the case of any offering on the EquityMultiple platform, the lender will have a proven track record and substantial industry experience, typically in the particular market and the asset class where they are lending.
Senior vs. Subordinate Loans
CRE debt can be secured by different collateral packages. Senior loans and A-Notes are generally secured directly by the property and are entitled to repayment of interest and principal prior to any other lenders. Consequently, senior loans are typically considered safer and garner lower interest rates.
B-Notes or junior participations in mortgages often share a direct security interest or lien on the property, but are subject to a participation agreement between the A-Note and B-Note holders. B-Notes are typically entitled to interest and principal repayment after an A-Note holder has been repaid, resulting in a subordinated investment and higher risk, and are compensated with higher interest rates. A-Notes and B-Notes are generally referred to as First Lien Holders as they have a senior interest in the physical collateral.
Mezzanine Loans are indirectly secured by the property by way of the Sponsor’s ownership interest and are subject to an intercreditor agreement between the first lien or senior lender and the mezzanine lender. Mezzanine loans generally have higher LTVs and are fully subordinate to any senior lenders (A-Notes and B-Notes) secured by the property. Only after the senior lenders receive interest and principal, will mezzanine lenders receive similar payments. As a result of this increased risk, mezzanine loans generally are compensated with the highest interest rates in a CRE debt structure.
The Bottom Line
Balancing high-upside and long-dated investments with stable, short-term assets can be key to portfolio diversification. The next time you consider allocating to fixed-income investment vehicles (or, perhaps, the next time you find yourself in a dentist’s waiting room), consider CRE debt and educate yourself on EquityMultiple’s past and current debt offerings.