Introduction:
Can commercial real estate investors benefit from debt financing? Find out here!
Returns on commercial real estate investments have been more difficult to earn as interest rates have risen, building expenses have risen, and property prices have risen. Real estate companies are moving beyond equity and into commercial real estate financing to provide predictable and regular profits.
Historically, banks and other traditional sources of capital, such as insurance companies or pension funds, were the principal sources of debt financing. However, greater regulation in the aftermath of the Great Recession has limited the quantity, type, and level of lending these institutions can perform, causing them to become more conservative.
As a result, commercial loans frequently fall short of what equity partners require today. Commercial banks typically lend no more than 65 percent of the property’s total value, and they have been limiting their exposure to commercial and multifamily real estate. The gap between bank finance and owner or developer money creates profitable opportunities for investors to fill – the middle of the capital stack.
Most of us grow old learning and believing that statement (or something like) is accurate. And it is, for the most part. But, like with everything else in life, context is everything.
For example, if you came to me and said you were unemployed, planning to max out four credit cards, and asking grandpa for a loan to buy a brand new F150, I would warn you that’s a horrible idea. And the “debt is bad” admonition usually refers to these types of transactions, consumer debt.
But what about borrowing in a different context? What if you’ve spent countless hours researching a specific investment that you believed had a decent possibility of return? What if you came to me and asked if it was a wise use of debt?
What Exactly Is Debt in the Context of Investing?
As explained, debt is borrowing capital (money or access to it) from another person or organization to obtain something (investment) that you cannot afford on your own.
Debt provides leverage. Taking on sensible debt provides you with leverage you would not have otherwise to make intelligent, well-informed investments.
As we’ve already stated, there is such a thing as good debt and bad debt. Credit cards are one example of bad debt. And using those credit cards to buy consumer goods they do not appreciate. That doesn’t mean we can’t have good things; it only means that, in my opinion, we shouldn’t buy nice things if we don’t have the money to pay for them.
Good debt would be a loan secured from family and friends or a bank that allows you to acquire (or invest in) items that increase in value, provide monthly cash flow, or provide a longer-term return on investment. I call anything like that commercial real estate!
For a long time, I’ve used the acronym “BURL” to distinguish between good and bad debt… it stands for Buy Utility, Rent Luxury.
If you can’t manage to buy a home for more than 100X the monthly rental cost, rent it instead. That eliminates both the problem of overspending as well as the problem of not being able to charge enough rent on that “super amazing deal” you just got on that duplex.
BURL can be changed for a geographic area, but it applies to practically any situation and will almost always keep you out of bad debt.
The Advantages and Drawbacks of Using Debt to Invest in Commercial Real Estate
Let us look at the gifts and liabilities of using debt to invest in my favorite game: commercial real estate. Debt isn’t always the solution, but it may be the only means to create generational wealth for most individuals. This is probably certainly the most apparent benefit on the list. When you don’t have any cash on hand, your investment choices are severely limited. Don’t be surprised; most people experience this difficulty, and most people can solve it.
Why risk your own money (assuming you have any) when you can risk someone else’s? Don’t get me wrong: I am NOT advocating for the rash purchase and deployment of other people’s money. However, every debt contracted in good faith comes with an understanding of risk on both sides. Use other people’s money, then do everything you can to invest it successfully.
The more the investment, the greater the potential return. Let me put it this way: if you only have a couple of thousand dollars to invest in real estate, 1) you won’t get very far, and 2) even if you do, the return on that amount will be low. However, if you had $100,000 to invest, you could see how it would open up a new world.
Leverage allows you to put less money into a deal and still make more money than you would on your own. This is, of course, the main point of this essay, allowing many people to enter the real estate market for the first time.
With debt, you can buy more homes, which gives you a better chance of a return on investment. However, it will also allow you to spread the risk across numerous homes and reap even bigger tax and appreciation benefits!
A Few Drawbacks of Using Debt to Invest Risk
First and foremost, you can lose a lot of money while using debt for investing. I mean, you could lose everything. That must be said unequivocally in this conversation. Even with the best due diligence, the risk exists in every financial transaction. If you cannot recover, take a hard pass and continue with a specific leveraged contract. Never, ever bet the farm.
Accountability to a lender or an investor
There is a genuine shift of power as soon as you sign on the dotted line (h/t David Mamet). You go from being entirely independent to being somewhat tethered to a creditor. Now, if you know what you’re doing, this shouldn’t be too difficult. But if you don’t, you may unintentionally enter a world of pain. In either case, when you take on debt, you no longer have complete control over your fate.
Having your ship in order would be best while looking for financial leverage. This is generally sound advice; who doesn’t want to go through life with everything in its proper place? However, pursuing outstanding debt takes this notion to new heights. You must demonstrate, sometimes in minute detail, that you can handle the debt you desire and that you will repay it on time and in full.
Penalties
Similar to the last “con,” there will be consequences if you do not follow the specific terms outlined in your loan agreement. Things can go wrong, from late fees to the bank calling in the loan. Sometimes, through no fault of your own (freak weather, economic downturns, etc.), you must be prepared to fulfill your promise to your creditor and to pay the price if you do not.
Yes, this one is lethal. If you’re going into debt, be prepared to do a lot of reading,
signing, and probably lawyering. The documentation in the acquisition of leverage is unending. It’s just how it is; the best thing to do is accept it and prepare your pen.
The Process of Commercial Real Estate Debt Financing
Investors in real estate debt operate as lenders to property owners, developers, or real estate corporations sponsoring agreements. The property is the loan’s collateral, and investors earn a fixed return based on the loan’s interest rate and the amount invested. Real estate debt is an excellent investment for a variety of reasons. It provides investors with diverse risk profiles, ranging from low-risk loans secured by stable, Class A buildings to higher-yielding opportunistic methods such as construction loans. For investors who do not desire to tie up assets for an extended period, debt investments can have a shorter holding duration than equity investments, with deals typically lasting between six months and two years. For yield-seeking investors, it’s a stable fixed-income instrument that generates cash income from the start.
Real estate debt investments are also less risky because equity is in the first loss position. When the value of a property falls by 10%, the debt investment is still protected, whereas the equity investor pays the total loss. However, lower risk means lower profit; the loan’s interest rate restricts returns.
How many risks Should I Take? Understand the Capital Stack
The capital stack is the organization of all capital invested in a corporation. The capital stack includes the stock and debt invested to date. More specifically, this refers to all forms of equity and debt.
This includes both common and preferred equity and junior and senior debt. These categories can be subdivided further. There are various sorts of preferred equity, for example.
The capital stack is the simplest method to comprehend how commercial real estate developments are financed, whether with equity or debt. It specifies who is entitled to the revenue and profits generated by property during its holding period and when it is sold.
The riskiest form of debt financing is at the top of the capital stack, and the safest is at the bottom. When a property is sold to others or refinanced, the lowest-ranking capital prioritizes everything stacked above it. Losses are accrued from the top down if there is inadequate money to repay any level of debt. From the bottom of the capital stock to the top, the most typical types of real estate debt are as follows:
Senior secured: Senior debt, the cornerstone of the capital stack and usually the most significant portion, is typically a mortgage secured by the property. It is also known as a senior secured loan or a first lien loan because the lender that owns the first mortgage on a property owns the first lien. Nonpayment gives lenders the authority to force the sale of the property to satisfy the obligation, making this the most secure sort of debt.
However, with that security comes a lesser (and, in fact, the lowest) degree of reward in interest rates than higher layers in the capital stack. Floating rates on senior loans are typically priced above a benchmark rate, such as the London Interbank Offered Rate or LIBOR. For example, a loan priced 200 basis points over LIBOR at 2.2 percent would have an all-in rate of 4.2 percent.
Mezzanine, or subordinated, debt: These loans are placed on top of senior debt, making them subservient to mortgage debt—they are paid after all senior debts have been met. Mezzanine debt, often known as Mezz debt, bridges the gap between bank loans and shareholder equity. After a developer or owner has paid off senior debt and operating expenses, all profits must be used to pay off mezzanine debt.
Mezzanine investors can foreclose on the equity position and potentially take over the property and the mortgage if payments are not made. Mezzanine loan returns typically range between 8% and 14% in the real estate industry. The range depends on the project’s risk and the amount of equity brought to the table by the sponsors. Our IncomePlus Fund is 25% mezzanine debt.
Preferred equity: While preferred ownership allows investors in a real estate venture the opportunity to be paid before common stockholders, it is pretty flexible. It can also kick out an owner or developer if they fail to make payments) to “soft” preferred equity may include some financial upside if a project does well but has more limited rights.
The boundaries of the preferred equity’s rights and the rate of return on its shares are specified in the offering agreements. If all debts are paid, preferred shareholders can collect profits until they hit the goal before common stockholders. Because it is senior to common stock, its expected risk and possible profit are slightly lower than common equity.
Common equity: This equity carries the highest risk because owners are compensated after all other lenders in the capital stack have been paid. However, it can also provide the highest benefits; to compensate for the greater risk, equity investors earn 100 percent of a project’s upside, which can amount to a substantial quantity of money if the initiative succeeds.
Even within the joint equity group, the developer or owner of a project usually receives a disproportionate share of the upside. The limited partners may provide 90% of the stock but receive just 75% of the upside. This aligns interests and serves as an incentive to excel. It also allows the sponsor to leverage their capital further within the partnership framework.
Finally, investors must decide whether they are prepared to give up the potential for higher payouts in exchange for a safer bet. Commercial real estate debt investing can offer risk-adjusted returns that compare favorably to predicted equity returns but with debt risk features and benefits. A real estate portfolio combined with equity and loan assets provides the highest potential for balancing risk and profit.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.