Debt Funds: What CRE Investors Need to Know

Matthew Wurtzebach  Image courtesy of Draper & Kramer

Owners who have not considered debt fund solutions are missing out on a growing and increasingly important capital source. For most transactions that fit a traditional bank profile, there is a debt fund that will provide more leverage with less recourse and greater certainty of execution.

Debt funds are the market’s response to increased government regulation of the banking industry since the financial crisis. Capitalized by a wide range of investors―from single source ultra-high-net-worth individuals and the traditional private equity cadre of family offices, endowments and pension funds, to life insurance companies―these alternative lenders have more flexibility on loan-to-cost, recourse, construction as a percentage of assets, and third-party report review, and their approval processes are more streamlined.

While terms vary based on transaction specifics, in today’s market, banks often top-off between 65 percent and 70 percent LTC on a structured loan with 50 percent to 100 percent recourse, while debt funds are routinely offering 70 percent to 80 percent-plus LTC with no recourse requirement beyond traditional carve-outs. Pricing on cash-flowing and “value-add light” assets (e.g., no large construction or future funding component) typically ranges between L plus 250 to L plus 350. L plus 250 means the note rate will equal LIBOR plus 250 bps (or basis points); L plus 250 is equal to about 5 percent today. Heavy value-add and pure construction will price at L plus 400 to L plus 600. Trophy assets in the large loan space will price tighter in all categories by as much as 50 bps. Relative to banks, the increased leverage and flexibility coupled with decreased recourse does come at a cost, usually in the form of higher fees and rates, but the incremental cost of capital for the additional leverage is often less than the cost of equity.

Fast and Flexible

Debt funds are also more nimble than traditional lenders because they are not subject to the same federal regulations that restrict bank activity. As a result, they can move quickly―sometimes closing loans in less than one week―often with creative loan structures that provide more flexibility than those offered by traditional lenders.

Investors are taking note. The Mortgage Bankers Association reports that debt fund originations increased 29 percent in 2018 to $67 billion. And, more lenders continue to enter the space. Perhaps that’s why a 2018 trends report released by real estate data firm Altus Group found that 82 percent of property development executives who responded to a survey reported they were utilizing at least one source of alternative financing in their capital stack.

Below are several scenarios where debt funds have found a comparative advantage:

Value-add acquisitions. In top markets, debt funds will provide 75 percent of the purchase with up to 100 percent of the future capex and TI/LC costs, non-recourse.

Short-term construction take-out loans: Replacing the initial construction loan, debt funds allow the sponsor to remove recourse, return equity to investors and stabilize the asset for eventual refinance or sale. On large, pre-stabilized, Class A multifamily assets, some debt funds have offered up to 100 percent of cost.

Ground-up construction: Because they are non-recourse and offer higher LTC ratios, with some as high as 85 percent, debt fund loans have emerged as an important source of construction financing―especially in cases where the exit has a relatively short horizon, as in student housing and some condominium projects. In select cases, debt funds have financed condominiums with no pre-sale requirement.

Some advice regarding use of debt funds:
Shop Around. According to Preqin, there were 395 private debt funds as of the beginning of 2019. About 70 are active in first mortgage originations. The landscape is becoming increasingly competitive. We have seen debt funds reduce minimum interest periods and waive exit fees to win strong deals.

Watch the Draw Requirements. If a project has a heavy value-add or construction component, make sure to carefully review the draw requirements. The terms can range from draw structures similar to what a bank would allow all the way to funding the full loan amount at closing, which has a large impact on interest costs.

Focus on Exit Assumptions.  As interim lenders, debt funds tend to size loans to an exit LTV that would allow for a reasonable CMBS or agency exit. A typical LTV for an exit to a CMBS loan would be 70 percent to 75 percent for most asset classes, while some HUD lenders will write to 80 percent or 85 percent. Providing strong support for exit assumptions up front will help you improve terms.

Understand how the lender will handle the loan post-closing. That may help you narrow the field of lenders. Some debt funds hold loans on their balance sheets; others will sell off an A-note to a bank and hold the higher-risk piece, or utilize CLO execution. This creates comparative advantages among lenders depending on the needs of a project.

In the current regulatory environment, debt funds are filling a capital markets void by offering more flexibility and creativity than traditional banks. Understanding how debt funds compete and which types of debt funds are best suited for a particular transaction, can add tremendous value to investors’ capital structures.