What is Real Estate Debt?

Real estate debt is an instrument that lends capital to purchase, develop, or renovate property. The property is collateral for the loan, and the borrower is expected to repay the debt over a set period. 

This debt instrument funds commercial real estate companies and can serve as a solid investment vehicle. Investors can add capital to the fund and earn returns from interest payments. However, like all investments, real estate debt has risks and benefits. investors should understand this investment before adding it to their portfolio.

How Do Real Estate Debt Funds Work

Real estate debt funds allow investors to act as lenders and use their capital to finance the projects of commercial real estate borrowers. Private equity companies back these funds and use their financing property as collateral. However, private equity companies don’t provide all the money; they find investors to act as lenders. Investors pool their money in the real estate debt fund, and that fund is used to provide capital to borrowers. 

Accredited investors earn returns through fixed-interest rate payments. The amount and frequency of these payments will be communicated in the investment terms. Investors should be aware that several non-interest-based fees may be deducted from their returns. These include due diligence, sourcing, management, origination, and exit fees. Investors should ensure they understand these costs before committing to the investment. 

Types of Real Estate Debt

Several types of loans fall under real estate debt. Each loan has a different purpose and, therefore, has different investment horizons, levels of risk, and returns. These loans include bridge, construction, and property rehabilitation or redevelopment loans. 

Bridge Loans

Bridge loans provide capital to borrowers experiencing short-term funding gaps. These loans bridge the gap until the borrower can secure more permanent funding or generate a more steady income. For example, bridge loans can help the borrower purchase a new property while waiting for a current one to sell. 

Since these loans are short-term, investors in real estate debt investing can see quicker returns. Bridge loans also have higher interest rates, meaning higher returns for investors. However, they can also be a bit more risky since there’s no guarantee the borrower will obtain long-term financing or capital.

Construction Loans

A construction loan is capital borrowed to build a new home. The loan disbursement is often staggered to coincide with certain project milestones. The borrower may receive part of the capital upfront and more after an inspection is passed or a foundation is built. This means the borrower must provide specific plans and comprehensive construction details.

Throughout the project and loan period, the borrower pays only interest. The principal is expected to be paid once construction is completed. However, many borrowers haven’t earned the capital to repay the loan and will refinance it, leading to more interest payments. Construction loans also typically require about 20% in a down payment. 

Land is typically the collateral since the project is not yet completed. Investors in debt funding will receive returns in interest payments. These loans also have fairly short investment horizons, ranging from six months to a few years.

Property Rehabilitation/Redevelopment Loans

These loans are for landlords and commercial real estate borrowers who need capital to finance rehab or redevelopment projects. Typically, these borrowers will take out a short-term loan to flip a property, then pay the loan back upon selling the property for a profit. Like construction loans, the borrower only needs to pay interest throughout the project. Once the rehabilitation or redevelopment is complete, the borrower is expected to pay back the entirety of the loan.

Rehabilitation loans are common choices for owners and developers who lack equity and need capital to finance their projects. The loan-to-value or LTV ratio on average is about 80% but can be more or less depending on the lender.

Who Uses Real Estate Debt as Capital?

Many commercial real estate projects may not qualify for traditional loans issued by mortgage brokers or banks. This could be because the projects are short-term or have a more complicated financial situation. 

Real estate debt funds are more flexible than traditional lenders and can provide capital more quickly due to faster closings. Unlike conventional lenders, they will also lend to borrowers with lower credit scores. Real estate debt loans will lend to a wider variety of developers, and their flexibility allows them to meet the needs of more projects.

Pros of Using Real Estate Debt

Real estate debt funds can be an excellent way for investors to achieve passive income and diversify their portfolios into real estate development projects. There are several advantages of real estate debt investments, such as:

• Steady income due to a fixed rate of return.
• Low risk since properties are used as collateral.
• Short hold times mean a quicker return on investment.
• Provides diversification into real estate.

Cons of Using Real Estate Debt

Real estate debt may only be the right fit for some investors. There are a few drawbacks that investors should consider, such as:

• Capped returns limiting growth.
• Risk of prepayment, which could interrupt and stop your interest payments.
• Possible inflation impacting returns over time.
• Limited to accredited investors.

How Do Real Estate Debt Funds Make Money?

Real estate debt funds can generate income mainly through interest. Real estate debt loans typically have higher interest rates when compared to other lenders, providing steady income to investors. Additionally, several fees lenders charge borrowers add to the income.

Upon closing the loan, repayment terms are finalized and agreed upon. These terms will determine the amount of interest the borrower pays. If the borrower defaults on the loan, the lender can claim ownership of the property used as collateral.

How is Real Estate Debt Different from Equity

Real estate debt is often confused with private equity real estate investments. While both are backed by private equity companies, there is one massive difference between them. Private equity real estate investments are equity-based, whereas real estate debt funds are debt investments.

Equity investments give the investors fractional ownership of the property itself. For example, investors pool their capital in private equity real estate investments to purchase a property. Returns are generated from the property’s growth in value. 

In debt investing, investors don’t own the property. Their capital funds a loan, making them lenders instead of equity owners. Therefore, returns are generated from interest payments, but they don’t have any equity in the property itself. Debt investing is often more secure, while equity investments have a chance at higher returns. 

Lend Your Capital to Grow Your Wealth

Real estate debt investing can be a secure way to diversify your portfolio into real estate without the risks associated with equity investing. Though it has capped returns, the securitized nature of the loans and fixed interest payments can provide steady income. Additionally, the short investment horizon means quicker returns on investments. To determine if real estate debt investing suits your portfolio, consult your trusted financial advisor!

Frequently Asked Questions