Real Estate Debt Fund Definition
A real estate debt fund operates as a lender for prospective real estate buyers or current asset owners (sponsors, operators, and developers). Investors in these funds receive periodic payments for the interest charged against loaned capital, and security charged against property assets, which takes the form of a mortgage. Constituent loans within the fund are typically collateralized by the underlying real estate — often via a senior mortgage or first lien. Real estate debt funds may take the form of a public or private REIT, or could be structured and operated by alternative lending sources like real estate crowdfunding platforms.
Real estate debt funds are a relatively accessible type of investment for individual accredited investors. As “fund” implies, these investments are diversified — a single investment brings the investor the potential downside protection of exposure to multiple assets. Real estate debt funds also typically offer the downside protection of securitization and payment priority.
Commercial real estate (CRE) debt investing is an option that can help provide investors predictable cash flow, relatively short target duration, downside protection, and a higher target return than many fixed-income alternatives in the public market. Plus, you’ll have the flexibility to choose between investing in a real estate debt fund or a single-asset offering. To learn more about real estate debt funds, how real estate debt investing works and more, read through this comprehensive guide.
What Is a Real Estate Debt Fund?
Real estate debt funds consist of private equity-backed capital used to issue senior real estate collateralized loans for commercial real estate borrowers. By investing in these funds, you’ll receive a return based on the interest assessed against loaned capital plus the benefit of seniority/payment priority to the other investment capital and the security of an underlying commercial property.
The Ascent Income Fund is a real estate debt fund built for individual accredited investors. It is built to capture the unique opportunities in real estate debt investing at this point in the market cycle.
Real estate debt funds can be used for different commercial real estate needs and offer loans collateralized by senior real estate assets. In many cases, real estate debt funds center around a specific loan strategy, such as funding multifamily real estate or shopping developments. The most common types of loans offered through real estate debt funds include bridge loans, construction loans and property rehab loans.
Real Estate Debt Funds — a Historical Perspective
The landscape of commercial real estate lending saw a dramatic shift post the 2008 financial crisis. Regulatory reforms, including Dodd-Frank and Basel III, introduced stricter liquidity and lending criteria for banks, significantly curtailing their real estate lending activities. This created a vacuum in the market, which real estate debt funds, powered by private equity, adeptly filled. Offering loans secured by senior real estate assets, these funds became a lifeline for developers and property owners in dire need.
Real estate debt funds are not a monolith; they specialize in a plethora of loan strategies to cater to the vast spectrum of commercial real estate requirements. From providing construction loans for multifamily apartment buildings to bridge loans for renovating office spaces, these funds offer the flexibility and terms that traditional lenders often cannot match. This makes them an appealing option for borrowers with intricate financial situations or those who find themselves outside the purview of conventional credit access.
As of mid-2024, inflation appears “sticky” and the Fed has signaled a “higher for longer” interest rate environment. This suggests rates that can be commanded by real estate debt investors may stay high for some time. In other words, real estate debt funds may enjoy a period of strong returns.
Bridge Loans
A bridge loan is a loan commonly used debt instrument for short-term financing. Bridge loans usually have high interest rates and provide the borrower with immediate cash flow, allowing them to meet any current obligations until more permanent financing is secured.
Construction Loans
Construction loans are used to help real estate developers cover the costs of construction. Using commercial real estate debt funds to fund construction costs is attractive to developers, as they often provide the advantage of only paying the interest during the duration of the project. This can help the borrower conserve cash flow.
Property Rehab Loans
Property rehab loans are loans designed to help borrowers cover the costs involved in renovating, repairing or restoring an existing real estate property. Similar to a construction loan, real estate debt financing is desirable to borrowers as they often offer interest-only payment plans.
Both individual debt deals and real estate debt funds can be found within EquityMultiple’s Earn pillar.
Who Uses Real Estate Debt Funds?
Real estate debt funds are used by commercial real estate borrowers to access loans and terms that they wouldn’t be able to receive from a traditional lender. In comparison to traditional lenders such as banks, real estate debt funds are much more flexible and can be used by real estate developers or sponsors to expand their capital stack and potentially enhance overall returns.
There are numerous reasons why a borrower would opt for a private lender rather than a bank, including:
- Quicker access to funding
- Prepayment flexibility
- The ability to structure a loan to best fit the project’s needs
- Additional debt capital above the level (LTV) a traditional lender would provide
This private loan market is generally closed to individual investors, but using an investment platform makes investing in these commercial real estate debt funds, which may provide attractive risk-adjusted returns, simple and accessible.
How Real Estate Debt Investing Works
When investing in real estate debt funds, you are typicall acting as a lender to commercial real estate borrowers. Real estate debt funds may offer interest rates (returns) of 8% or more but can vary based on the state of capital markets. These interest rates are fixed, and borrowers must make monthly payments on the loan. In addition, borrowers may be subject to pay non-interest-based fees, including due diligence, servicing, modification, extension, draw, origination and exit fees. Depending on the type of fund, investors may receive these payments in whole or in part.
Real estate debt loans are secured by real property, typically through a mortgage or deed of trust. If a borrower defaults, the lender may take control of the property. To avoid these scenarios, some platforms (such as EquityMultiple) pay close attention to loan-to-cost, loan-to-value, and debt-service coverage ratios (DSCR) when assessing the risk of the borrower and their project. This allows for debt investment opportunities that can provide attractive risk-adjusted returns to individual investors.
Most lenders require the borrower (or “sponsor”) to contribute a certain percentage of their own capital to a real estate project, much like a bank issuing a residential mortgage would require a down payment. EquityMultiple typically targets loans with a loan-to-value (LTV) ratio of 75% or lower.
This serves two purposes:
- Ensures that the borrower has “skin in the game,” and aligns the interest of both the lender and sponsor for the success of the property while incentivizing the borrower to make timely interest and principal payments.
- Provides a cushion for the lender (and thus EquityMultiple’s investors) to recover its investment if a property declines in value, particularly if a sale or foreclosure is necessary.
Because CRE debt investing is a form of senior debt, you’ll be granted security within the capital stack, meaning your investment will have top priority against any other investments involved in the property. In addition, real estate debt funds often invest capital into numerous projects simultaneously, further minimizing your risk and diversifying your portfolio.
Pros and Cons of Investing in Real Estate Debt Funds
No matter what you invest in, your return potential is always a function of risk. Real estate debt funds are no exception. To better understand the risks and rewards of real estate debt investing, take a look at the pros and cons.
| Pros | Cons |
|---|---|
Pros of Real Estate Debt Investing
For investors, many unique benefits make investing in real estate debt funds an attractive option for meeting their goals, including:
- Low risk: These loans are secured by real property, typically through a mortgage or deed of trust. In the event of a default, the debt fund manager may take control of the property and has the ability to recoup their investment.
- Steady income: Investing in real estate debt provides you with consistent monthly payments. These payments will bring a fixed rate of return depending on the established interest rate on the loan and the amount that you’ve invested.
- Short hold time: Commercial real estate debt investments are associated with real estate development projects, meaning that the loan should be paid in full soon after the real estate project is complete. In most cases, the holding period for a real estate debt investment is six months to a few years.
While these advantages make real estate debt investments exciting for some investors, it also has its drawbacks.
Cons of Real Estate Debt Investing
Of course, no investment is perfect. Some of the downsides to investing in real estate debt include:
- Capped returns: Because your returns are based on a set interest rate, your returns are limited, unlike an equity investment in which you have unlimited earning potential.
- Risk of prepayment: If the loan is paid off early, your cash flow from interest payments can be interrupted. However, liquidity is never a bad thing for most investments, so this may be viewed as a positive in some cases.
- Possibility of inflation compromising real returns over time: Depending on the inflation rate during the time of your investment, it’s possible that inflation can cut into your returns.
In 2024 and beyond, we can expect the pros of real estate debt investing to magnified, while the cons are muted. Again, this is due to macroeconomic conditions. While the economy continues to show broad strength, there is a supply/demand imbalance in capital markets: investors in real estate debt can potentially capture “equity-like” returns while still benefitting from the downside protection of real estate debt positions.
Now that you know the pros and cons of real estate debt investing, let’s take a look at how it compares to another type of investment: equity investing.
Real Estate Debt Investing vs. Equity Investing
While both are a form of real estate investing, CRE debt investing and equity investing have their differences. One of the key differences between the two is the role of the investor. If you invest in real estate debt, you’ll be acting as a lender to commercial real estate borrowers (or taking part in a syndicated loan). On the other hand, equity investments make you a shareholder in the property you invest in.
Equity investments depend on sound execution of the business plan, typically involving some combination of renovations, lease-up, and repositioning. Because your returns are dependent on excess cash flow and a successful exit (sale) equity investments are riskier than debt investments. This increased risk also provides investors with a higher earning potential than debt investments, which are determined by interest rates. Conversely, real estate debt investments are a stable alternative, providing steady income and capped returns.
Another key difference between debt and equity investing is the desired holding period. Some real estate debt investments, such as bridge loans, have shorter terms, often ranging from six months to a year. Other times, real estate debt investments may last the duration of the development project, which can last up to a few years. With an equity investment, you’re investing in the future value of the property. Because of this, you’ll likely hold your investment for much longer, sometimes from five to 10 years. The key point is that debt investments typically involve contractually obligated returns. This doesn’t mean they are risk-free, but your fixed rate of return will be more immediate and certain in the case of a debt investment.
The Bottom Line
Real estate debt funds are a cornerstone of the commercial real estate finance ecosystem, offering flexible, timely financing solutions that benefit both borrowers and investors. Their role in the real estate market is poised for growth as they continue to provide attractive investment opportunities and fill the gaps left by traditional lending sources.
For accredited investors seeking to diversify their portfolios with commercial real estate investments, EquityMultiple serves as a bridge to a world of meticulously vetted real estate debt fund opportunities. While equity investments may be attractive due to their uncapped returns, investing in a real estate debt fund provides a great way to invest in different real estate projects without actively monitoring a property. EquityMultiple conducts extensive due diligence on co-lenders, borrowers and the underlying real estate securing the loan, offering participation in commercial real estate debt investing for as low as $5,000.
Real Estate Debt Funds — FAQs
Still have questions about CRE debt investing? We have answers.
Q: What is a real estate debt fund?
A: A real estate debt fund is a pool of capital, often backed by private equity, that lends money to real estate buyers or current owners. These loans are secured by real estate assets, offering investors income through interest payments and, in some cases, property acquisition in the event of defaults.
Q: How do real estate debt funds generate income?
A: Income is primarily generated through interest charged on the loans they provide. Additionally, in cases of default, funds may gain income by taking possession of the collateral property, which can then be managed or sold for profit.
Q: Why have real estate debt funds become popular?
A: They have filled a crucial gap left by traditional lenders, who have become more restrictive in their lending practices due to regulatory changes. Their flexibility and rapid capital provision make them an invaluable resource in the real estate market.
Q: How can I invest in real estate debt funds through EquityMultiple?
A: Accredited investors can join EquityMultiple to access a curated selection of real estate debt fund opportunities. Our platform provides detailed information and support to help investors make well-informed decisions.
Q: Are Debt Investments Good?
A: Debt investments can be a good option for those looking to accomplish short-term financial goals with a generally lower financial risk.
Q: Is Real Estate Debt Good Debt?
A: Generally, real estate debt is considered good debt because it is backed by a real, tangible asset.
Q: What Sets Real Estate Debt Funds Apart?
A: Real estate debt funds are unique as they offer flexible bridge financing. Following the 2008 housing crisis, new regulations restricted the lending capabilities of traditional lenders. To fill this gap, private lenders, including real estate debt funds, began providing funding for commercial real estate borrowers.
