Private real estate debt is having its moment in the sun. The current economic turmoil is actually a good thing for private debt – from the private debt manager’s perspective and for private debt investors.
- Property values are on shaky ground.
- Costs are higher and that puts pressure on net income.
- Interest rates are high and that puts pressure on net cash flow.
- Conventional lenders are tightening credit standards.
- Borrowers still need capital.
For investors who like real estate but are not sure now is the time to buy, investing in a debt position is a viable way to generate cash flow in a more protected position and today’s rates are almost the same as what investors previously expected to earn in an equity position.
If you want to invest in real estate in a debt position, here are two options to consider.
- Write loans direct to borrowers. This is probably not a realistic option for most individuals, but it’s possible so it’s included here.
- Invest in funds managed by professionals. This is very realistic and a much easier option for most individuals. When considering this option, there are many nuances to figure.
Debt funds can vary by fund size, asset type, geographic focus, borrower profile, duration, risk tolerance, and so on. We will look at the differences between large and small real estate debt funds.
LARGE FUNDS
A large fund is typically $500M or more. Some of the larger debt funds are multiple billions of dollars in size. Some of them originate direct to borrowers and some buy loans or pieces of loans in the secondary market. Below are some generalities about the larger funds.
Benefits
- Diversification – Theoretically, a larger fund may have the ability to be more diversified across many loans so that there is less exposure to the performance of any single loan. However, this isn’t always the case because fund managers are incented to get the money to work as quickly and efficiently as possible. A $5M loan requires the same amount of time and expense as a $100M loan, so all things being equal fund managers may do ten $100M loans instead of two hundred $5M loans.
- Sponsor Team Depth – Larger funds are run by institutions with experienced individuals and with management structures with multiple levels of personnel.
- Safety In The Herd – This is a psychological benefit – peace of mind, in a way. There can be a comfort when investing alongside household names or with brand name fund managers. If things go badly, not too many people are going to question an investment in a massive brand name fund.
Drawbacks
- Gate Fees – it can cost an investor 10% to 12% just to get into a large fund. Most of the large funds use third party firms to raise capital and these third-party firms often engage with other service providers to broaden their reach to retail investors. Add the requisite regulatory fees and costs and the Gate Fees compound. A 12% fee load means that for every $100 an investor puts in a fund, only $88 are actually put to work. Fund fee structures can vary, but generally that load impacts the investors.
- Management Fees – These large funds with a deep bench require hefty fee income to operate. The fees may be shown as a percentage of assets under management plus there may be other fees charged for different administrative tasks. They are not hidden per se but they aren’t advertised up front either. Fees are ultimately dilutive to investors.
- Market Risk – the larger funds almost by definition are not nimble. It can be difficult for a fund manager to avoid a downturn when their capital is spread across large positions.
- Conflicts of Interest – the larger fund managers are often on their 4th, 5th, 6th, etc. fund. While they’re managing one fund, they may be investing the money from another. This may be fine when things are going well – but it can be dicey when one legacy fund is not performing well and requires extra attention to work out.
SMALLER FUNDS
Benefits
- Nimble – Smaller funds can be more selective and take more of a rifle shot approach. They can focus on a certain property type in a specific region for example. They may also be able to make decisions more quickly, and that responsive could help them win better deals in their markets.
- Low Fees – Smaller funds typically have more efficient fee structure. Investors can usually invest directly in the fund and not pay excessive gate fees. A Gate Fee to get into a smaller fund direct may be more like 3% to 5%.
- Management experience and access – Investors will typically have better access to the fund manager and can have a personal relationship with the fund manager if so desired. This can help the investor have confidence in and knowledge of the fund manager’s decisions and expertise. Being a $5M investor in a $100M fund gives that investor some gravity, versus a $5M investor in a $1B fund.
Drawbacks
- Deal Profile – Some small funds may be lending to smaller and less sophisticated borrowers. The overall quality of the project could be weaker. This isn’t necessarily the case, it varies by strategy.
- Market Limitations – the smaller funds can be less able to pivot and react to the market. For example, if a fund is focused on a market that is in a downturn it may be difficult to make good loans unless it can enter a new market.
- Management Depth – the shorter bench can lead to a higher keyman risk with more reliance on the performance of one particular person.
If you are an investor or advisor and would like to discuss real estate funds and meet fund sponsors, please feel free to reach out to John Churchward at 617.356.4656.
Mr. Churchward is a capital markets professional with a career spanning more than 25 years. Since graduating Brown University with an Engineering Degree, Mr. Churchward has been working in the commercial real estate industry as institutional lender, sale/leaseback buyer, developer and advisor. Today, Mr. Churchward is working with former colleagues and partners seeking opportunities for attractive risk-adjusted returns in either an equity or debt position secured by commercial or residential property nationwide.
