Private real estate debt funds are becoming the go-to choice for many investors. I believe these funds offer many advantages including portfolio diversity, significant downside protection, low volatility and consistent cash returns. But as is the case with all investments, no two private real estate debt funds are alike. Because of this, investors must understand how the fund fits in with their financial goals. To that end, any potential private debt fund analysis should include the following.
The purpose of private debt funds is to lend money. This isn’t too different from the role of traditional lenders, like banks or credit unions. While traditional lenders lend money from the banks’ deposits, private debt funds raise capital from investors for their lending purposes. Investors receive returns from the monthly coupons paid by the borrowers and then usually additional compensation when the loan is paid off.
As such, many private debt funds are based on a hold-to-maturity approach. In other words, investors remain with the fund until loan payoff or maturity. That maturity date can vary, based on the fund’s strategy or purpose. If the fund issues short-term bridge or mezzanine financing, the maturity date could be less than two years typically. Other funds might issue loans with a 10-year term. Investors need to understand loan terms to understand how long their capital will be tied up in the fund.
Additionally, it’s important to know if the fund is open-end or close-end. Open-end fund sponsors consistently raise capital to take advantage of ongoing opportunities. There is no “start” or “end” date to these funds. This means no specific timeline or deadline for investor subscriptions or redemption. Close-end funds, on the other hand, raise a specific amount of capital for particular projects. Investors must remain with that fund until the loan is paid off or it matures.
A private debt fund’s strategy focuses on a couple of key factors:
- Loan types (i.e., mezzanine, bridge, senior)
- Underlying commercial real estate assets and their fundamentals including geographic locations, local market economics, population, etc.
Investors should understand a fund’s strategy to get a better idea of its risks and/or exposure.
For example, Revere Capital’s fund strategy focuses on lower middle-market loans to real estate projects in predominately primary and secondary markets. Additionally, Revere Capital’s emphasis is on low-volatility real estate assets with a low correlation to leading indices. From this, investors know that Revere Capital isn’t interested in large-loan projects or riskier opportunistic plays.
One caveat here is that some private debt funds might not follow the specific strategy originally presented. To mitigate this possibility, investor due diligence should also involve:
In many cases, investments warn that “past performance is no guarantee of future results.” Interestingly enough, this is not always the case with private debt funds. When evaluating these funds, past performance is often an excellent indicator of future performance.
This is because reputable private debt fund sponsors issue loans to specific target assets and locations. For example, if a fund provides bridge loans to multifamily developers in the southeastern United States, those loans’ payback period and returns can be used to understand the performance of future loans that are issued.
Another past performance issue is how often a private debt fund has had to take ownership of a real estate asset due to default. Too many loan foreclosures could be a warning sign.
Operational Knowledge and Strategies
Private real estate debt funds lend to real estate investors, owners and developers. Because of this, it’s important that the fund’s sponsors have in-depth operational and strategic knowledge of targeted real estate assets.
This is important because:
- Experienced fund sponsors can provide advice and suggestions to borrowers on issues like how to enhance asset value or when to bring an equity partner in for capital assistance. This can lead to repeat borrowers and more opportunities for investors.
- If the borrower should default on a loan and the fund takes ownership of the asset, savvy fund sponsors can continue operating that asset to help grow its value.
Sponsor’s Capital Commitment
In many cases, sponsors and managers will add their own capital to private debt funds. This gives them “skin in the game;” they sink or swim with the fund along with the outside investors. A sponsor’s willingness to risk their own money in a fund can provide a measure of comfort to outside investors.
The Importance of Leg Work
Though private debt funds are fast becoming popular among investors, investors should spend time investigating these funds before committing capital to them. Due diligence can reassure investors about the reputability of private debt funds. Additionally, an in-depth understanding of how the various funds operate allow investors to select the right ones that match their particular portfolio and financial strategies.