Familiarize yourself with the art of the debt fund

Leon McBroom
Director, HFF

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More and more, the term “debt fund” has been thrown around in the debt capital markets, and it’s a term more borrowers should understand.

Last year, we closed 21 transactions with debt funds in Denver. This was a 300 percent increase from 2018, which accounted for more than 20 percent of our total Denver loan volume. Notable debt fund deals on which we advised included Block 162, 930 15th St., The Edge Condos and 1660 Lincoln.

What is a debt fund? A debt fund is a pool of private, largely nonregulated capital that targets a specific lending strategy. These “alternative” lenders have become a dominant force in the commercial real estate debt capital market due to their creativity and customization, speed to close and more favorable loan structures due to little regulation compared to banks. This has translated into market share within the commercial real estate debt capital markets.

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While the national trend isn’t as robust to what we saw in Denver, the national trend still is one of notable year-over-year growth. In 2014, debt funds had two percent of total market share. In 2017, market share for debt funds jumped to 10 percent, and, through the third quarter, debt funds comprised 12.1 percent of the total real estate debt market. For comparison purposes, commercial mortgage-backed security accounted for 13.8 percent of the market, according to the Mortgage Bankers Association, which classifies debt funds as “other” lenders. Increased market share equates to an abundance of liquidity in the debt fund capital markets.

Why has the landscape shifted? The debt fund capital markets have seen substantial growth, driven mostly by borrowers abandoning banks and other traditional floating-rate executions in order to seek more creative financing solutions. Three big drivers are nonrecourse, structure and the ability to push leverage.

  • While the sponsor is important and can greatly impact final economics, debt funds lend on the real estate and the corresponding business plan. A debt fund will use sound underwriting to show a clear path to repayment; therefore, debt funds are not looking for a repayment guaranty.
  • Structurally, debt funds can get creative and build in features such as a pari-passu funding structure. This allows borrowers to fund their equity alongside each loan draw, enhancing project level returns.
  • The ability to push leverage has allowed borrowers to manufacture a more efficient capital stack while substituting equity for a lower cost of capital from a debt fund.

How are debt funds raising their capital? There is a significant amount of liquidity in the debt fund capital markets. Currently, there are 63 debt funds in the market with an aggregate target size of $23.6 billion in capital to deploy, according to Preqin. Debt funds are raising capital from domestic and international pension funds, endowments, family offices and even high-net-worth individuals. All have identified commercial real estate as an target asset class and are looking to manufacture a return based on different tolerances of risk.

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How are debt funds deploying their capital? Debt funds are deploying their capital into three different return profiles:

  1. Core plus – good cash flow with minimal lease up and capex work;
  2. Value add – low vacancy coupled with need to deploy capex dollars; and
  3. Opportunistic – new construction or reposition.

The chart provides a high-level overview of the general terms.

While everything points to a floating-rate execution, a recent evolvement in the debt fund space is a fixed-rate option. This option allows for you to fix the rate day one and eliminates the need for an interest rate hedge while maintaining all other debt fund terms and structure.

Are all debt funds created equally? The short answer is no. In fact, the term “debt fund” is very broad. Debt funds encompass mortgage real estate investment trusts, life insurance company balance sheets, real estate private equity groups and family offices. Furthermore, most debt funds manufacture a return within the loan they are making. Said differently, most debt funds are focused on manufacturing a subordinate piece in order to generate the highest yield. As such, most debt funds lay off the senior piece of their loan. The senior piece of the debt stack is priced lower allowing for the total cost of capital, or the blended spread, to be accretive. Debt funds accomplish laying off the senior in a variety of different ways:

  • Warehouse line: Backed by the credit of the funds limited partnership equity commitments.
  • Bank A note: Typically provided by banks and insurance companies. The bank is typically buying a lower-leverage position within the debt stack.
  • Collateralized loan obligation: A reinvestment of proceeds sold through a securitization.

Due to the varying levels on how certain debt funds are structured and manufacture their internal returns, it is extremely important to go into the space with an abundance of caution.

A debt fund execution is worth considering for your next short-term financing need. Use the art of the debt fund to your advantage in manufacturing a loan solution that works best for your business plan. Evident to the volume our office experienced in 2018, the debt funds are targeting Denver to deploy their capital and welcome your debt capital stack needs.

Featured in CREJ’s March 6-19, 2019, issue

Edited by the Colorado Real Estate Journal staff.