There is a significant rise in the private real estate debt funds since it is born in 2009 and 2010 as an aftermath of the financial crisis. This is primarily due to the reason that:
- The traditional banks were paralyzed and remained thus failing to provide debt liquidity of any kind to people.
- This is the time when the private ledgers grabbed the opportunity with two hands and emerged in the real estate market to fill up the void thus created.
Since then, private lending has become a significant part in real estate funding and has grown with each passing year now becoming a full grown major industry.
According to research by Prequin in 2015, there are a few promising and notable facts revealed such as:
- The official private debt funds secured an amazing $85.2 billion mark in global commitments
- The institutional debt fund in North America alone totaled to $49.6 billion
- The returns generated by the private debts funds are high enough with more than 86% of investors admitting that they are satisfied with the rate and
- 46% of the investors polled even planned to increase their private debt allocations in the coming years.
All these reveal the popularity of private debt funds with real estate investors. Now, the natural question that may come up in your mind is why private debt funds have become so popular is such a quick time? Well, that is primarily because private real estate debt funds usually follow multiple strategies and one of the most significant one is direct lending which is currently the most popular form of private debt fund.
About direct lending
Direct lending, just as the name signifies, are loans that are provided by the private lenders to the borrowers directly. Within the direct lending periphery, it is found that real estate happens to be the most popular and secure type of collateral which resulted in such stupendous rise in real estate direct lending funds.
There are a few key points to understand in this aspect better that involves the working process of these funds, the risks associated with these and the rewards that they have in store for the investors. With such understanding, it will be easier for you to explore this opportunity and find whether you fit in such a diverse and rewarding real estate portfolio.
- Real estate direct lending funds are essentially pools of private capital that is backed by equity.
- These debts have specific mandates and objectives to create high-ranking real estate collateralized loans for eligible mortgagors.
- Generally, most of these private funds are specifically structured to support and execute a definite loan strategy or an investment thesis.
- These funds can originate a residential construction loan offered to single family home builders but has to be collateralized by the first deeds of trust on the real estate that is undergoing construction.
- The collateralized loans mitigate the risks of such debts and help the lenders to manage their capital exposure more effectively and efficiently. This is because the lenders fund their loans in parts and tranches as and when a specific phase of the construction occurs and is completed.
However, just like you will go through the debt consolidation reviews to find out whether or not it will be a feasible option for you to choose, you must also know all the pros and cons of private real estate debt funding before choosing to invest.
Differ from equity
Another significant thing to understand when you want to invest in private real estate funding is its difference with equity investing. Typically and technically, there is a vast difference between the two.
- Debt investing primary emphasizes on mitigating risks from it in all possible ways and from all possible turns in order to simply optimize the likelihood of earning a higher and fixed rate of return as well as for collecting the specified fees.
- Conversely, in equity investing the main objective is to seek for those multiple paths of probable upside to reimburse for those inherent downside risks of investing and losing the entire amount that has been invested to any debt holder.
This means the critical distinction lies in the underlying loan of debt investment where the loan supported by a hard asset as its collateral. This is certainly not funding a business plan of someone else that they hope to achieve. It is, in fact, a direct business done with partnership with the debt holder without having to focus too much in the business operation and worry too much about the returns.
In addition to that, such loans are made only up to a specific percentage of the total initial value of the hard asset. This means that the integrity of such a debt investment is typically cloistered from the asset value and essentially declines up to the entire amount of sworn equity.
Other questions answered
If you want to start investing in real estate through direct lending you may be wondering how you may make money from it. Well, you will make it from the interest rate or the lending rate that you will charge over the entire tenure or term of the loan. You may also charge a few other fees for the entire life cycle of the loan such as:
- Origination fees
- Exit fees
- Early termination fees and
- Extension fees.
As an investor, you can also make money from the interest coupons as return on your principal amount which will become the ordinary income distribution for your tax purposes.
If you wonder about the downside risk of direct lending then be informed that this too has some amount of risk just like any other form of investment. However, these risks can be easily mitigated through the debt structure such as lower loan to value ratio.
Therefore, if you are wondering why invest in direct lending funds there are three specific reasons to do that such as:
- Steady current income
- Security in the capital stack and
Such loans optimize predictability, loan performance and mitigate single loan risk exposure.