How Real Estate Debt Funds Work

Real estate debt funds assist borrowers in sourcing short-term capital to use towards commercial projects such as construction loans, multi-family buildings, shopping centers and many other types of property development.

Real estate debt funds became highly utilized following the crash in 2008. Post-financial crisis, there was an increased need for liquidity and coupled with regulatory changes, banks, as well as many other capital lending sources, were forced to either become strictly cash flow-based lenders (as opposed to asset-based) or pull back from commercial real estate lending all together. Today, in the world of commercial real estate lending, real estate debt funds represent a relatively small but nevertheless profitable niche.

What is a real estate debt fund?

A real estate debt fund is essentially private equity-backed capital that assists either current real estate asset owners or prospective buyers by lending them money. Real estate debt fund investors receive payments periodically from the interest that is charged against the loaned capital, as well as security charged against the property’s assets, essentially taking the form of a mortgage. These funds provide borrowers with loans that are collateralized by real estate assets to finance a wide range of business and commercial real estate needs.

Most real estate debt funds focus on a particular investment idea or loan strategy. For example, some may concentrate exclusively on offering loans to multi-family property builders for residential constructions, while others may focus on financing shopping and retail developments. Other loan types that are common include construction, industrial, hotel/hospitality and vacant land.

Who uses debt funds for capital?

Commercial real estate borrowers can turn to debt funds to access loans and terms that traditional lenders either cannot, or will not, offer them. Debt funds work with borrowers experiencing complex financial situations or those that, for whatever reason, can not access conventional forms of credit.

The most common debt fund loan types include:

• Construction loans
• Bridge loans (or lease-up financing)
• Redevelopment/Property rehab loans

What makes real estate debt funds different?

Following the housing crisis of 2008, banks and other traditional lenders were suffering from major liquidity issues, and credit for commercial real estate all but dried up. New regulations introduced as a result of the crisis created even more restrictions for traditional lenders, further limiting the types of loans they could offer. Real estate funds, as well as many other private lenders, stepped in to fill this gap and began lending to businesses and commercial real estate investors.

Although banks and CMBS (Commercial Mortgage Backed Securities) lenders are once again providing loans for commercial capital, many of the traditional lenders are yet to focus back on borrowers who need construction or bridging loans. This sector is still largely in the hands of other private financing sources, including debt funds. For borrowers who need amounts that are not large enough for non-bank institutional lenders but too large for small lenders, debt funds offer capital between those two extremes. This is generally in the region of less than $100 million in capital.

For businesses that need capital quickly, debt funds boast streamlined processes that can meet their needs faster than the more traditional lenders. This efficiency can be particularly attractive to the real estate sector, where tight completions are common and failure to secure funding quickly can spell disaster. Developers and owners that lack the balance sheet or the equity to satisfy traditional lender criteria may also turn to debt funds for capital loans.

How do real estate debt funds generate income?

Most of a real estate debt fund’s income is generated through interest charged on the capital lent – and by obtaining a title to the underlying collateral in the case of a default. Borrowers are typically charged interest rates starting at 9% and these can fluctuate in accordance with market conditions. Loan payments are made monthly, and rates are typically fixed. Other borrower fees may include origination, due diligence, draw down, extension, modification and exit fees. Depending on the type of the fund, these fees are non-interest based and are distributed to investors either in whole or part.

Loan amounts offered can range from $5 million to as much as $150 million or more. Short-term loans are available, for example 1-3 years. The LTV (Loan-To-Value Ratio) or LTC (Loan-To-Cost Ratio) for the loans depends upon the particular attributes of the property and its location – typically, though, it is never greater than 80%.

Final thoughts

In recent years, real estate debt funds have come to occupy a significant place in the markets that deal in commercial real estate financing. They have assisted in the construction of thousands of commercial properties across the U.S. and have provided billions of dollars in capital funds to developers and investors. Their efficiency and accessibility makes it probable that real estate debt funds will hold their critical space in the real estate markets for the foreseeable future.