Debt Funds

What is it?

The term Debt Fund has been heard in the capital markets more often and it’s a term that CRE investors and borrowers should understand and get familiar with.

What Is a Debt Fund?

A CRE debt fund is a pool of private capital that lends to real estate investors, developers, builders, landlords and operators. A debt fund offers high-creative and flexible lending solutions. Debt funds are also called “alternative lenders” who have become a dominant force in the CRE debt capital market due to their creativity, flexibility, customization, and speed to close loans with more favorable loan structures than conventional banks.

Why is the CRE Lending Industry Shifting to Private Funds?

Private debt funds have seen a substantial growth driven mostly because the borrowers are abandoning the banks and other traditional financing institutions in order to get more creative financing solutions. Banks cannot compete with private funds due to the red-tape and all the regulations banks must face.

The most common reasons are

  • Speed

  • Flexible and Creative Solutions (Structured Financing)

  • High leverage

While most banks focus on the sponsor, credit scores, payment history, tax returns, financials, and its capability to re-pay, private debt funds lend based on the real estate and the exit strategy. Although a private debt fund will underwrite to show a clear path to repayment; they don’t focus exclusively in the borrowers/sponsors’ repayment capacity. 

How Does Private Debt Funds Raise Capital?

Private debt funds are raising capital from pension funds, endowments, family offices and HNWI (high-net-worth individuals). Accredited Investors have identified the potential of the CRE lending and investing on those because of the capacities the debt funds must deploy capital and to generate returns for its investors based on different tolerances of risk.  

How Does Private Debt Funds Deploy their Capital?

  • Lending Funds – Lending to RE Investors. Usually up to 70% LTV and generating returns from 9% to 12%

  • Note to Notes – This is like Fund of Funds (Lending to Private Funds secured either by a Note or a pool of Notes) This is the safest position on lending and usually up to 50% LTV and with returns of 6%

  • Preferred Equity – Value-Add projects and Construction loans require creative financing solutions, and private equity is a great source for it. Prefer Equity can go up to 85% LTV and gets a prefer return of 16% plus the possibility of the upside.

Why Private Debt Funds get Leverage?

Private debt funds can subordinate a piece of the loan to generate high yields. The senior piece of the debt stack is priced lower, allowing the total cost of capital to be more attractive to the borrowers. Debt funds can get leverage in a variety of different ways:

  • Warehouse line

  • Bank (Note to Notes)

  • Fund of Funds

  • CLO (Collateralized Loan Obligation)

Are all Private Debt Funds Created Equally?

The answer is no. When deciding investing on a mortgage fund, it’s important to look at the fund and how it’s performed over the last years, however it is more important to evaluate the experience of the fund manager.  It can be tempting to get tunnel vision and focus only on funds that brought stellar returns in recent years, but managers play a huge role while analyzing performance and risks.

Make sure you select a fund manager (and not a fund) who has the character and capabilities to overcome situations during a market shift. Managers must have a strong strategy for those days, a well-seasoned asset management team, risk-management policies and procedures, a full understanding of the market their serve as well as clear competitive advantages.

Investing in private debt funds is worth considering, however due to the different levels on how certain private debt funds are structured to generate returns for its investors, it is extremely important to go into the space with abundant caution. Many investors run their own process to select the best private lending funds and most of them focus on the character and resources of the manager, and not on fund’ s past performance.

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