Many real estate debt fund managers incorporate leverage into their investment strategies. Understanding how a fund manager approaches and manages this exposure throughout market cycles can be an important part of selecting the right strategy for your investment goals, especially in uncertain and volatile economic times.
What is Leverage in Real Estate Debt Funds?
Real estate debt funds offer investors another way to invest in real estate markets and diversify portfolio income. These strategies invest in commercial real estate loans through financing the acquisition or recapitalization of commercial properties, and their returns are largely driven by the interest charged by the collateralized loans held in their portfolios. Investors are drawn to these strategies due to current income, lower volatility, downside protection and reduced interest rate risk via floating rate exposure. In contrast, real estate equity funds generally own the underlying properties in their portfolios and seek to generate rental income and capital appreciation.
Because of this, real estate debt funds tend to be viewed as lower on the risk/reward spectrum compared to real estate equity funds. The relative stability of the underlying loans held by these strategies, however, make them ideal assets for applying leverage. As a result, many managers seek to enhance performance through the strategic use of leverage.
How it typically works: First, the fund manager originates a loan for its portfolio. The fund then takes an additional loan from a bank or other financing provider to fund a portion of the original loan, using the underlying collateral. This frees up capital for the portfolio, allowing it to hold more loans with less direct investment. Consequently, the fund manager's potential return from the original loan is enhanced, since it is capturing the same level of interest income with less capital, minus the costs of the new loan from the bank or financing provider.
Hypothetical example based on a levered senior loan:
The fund manager is making a senior commercial real estate loan for $70 million, with underlying borrower equity of $30 million (30%). Leverage is therefore 70% and the full capital structure is $100 million. To capitalize the loan of $70 million (also known as the "Whole Loan"), the fund then borrows $42 million (60%) against the original collateral and directly funds the remaining $28 million (40%) with the fund's equity. This example is illustrated in Exhibit 1. Other types of leverage financing can vary in terms of how much of the original loan equity is retained by the fund and how much can be borrowed.
Why do Funds Utilize Leverage and What Additional Risks Does it Pose?
Leverage can be a valuable portfolio management tool that offers a way to adjust return potential by adding varying levels of risk. With this in mind, itis important to think about leverage use strategically given the specific portfolio to help ensure that the appropriate strategy is utilized to achieve the desired risk and return results.
This starts with degree of exposure. Generally speaking, thehigher the leverage level, the greater the potential increase in returns. Leverage, however, also amplifies risk and the potential for a full capital loss of the investment. If the original loan defaults, the underlying collateral is still subject to the additional leverage, potentially placing the fund's capital at risk of impairment if the property value declines below the loan's par amount. Broader economic and market conditions may also affect leverage risk exposure. For example, as interest rates rise, leverage can become more challenging to manage. It can also potentially elevate distress in periods of illiquidity or market disruptions as experienced on several occasions over the past year.
The strategic use of leverage can be more nuanced than magnitude alone. Different applications can entail various levels of risk exposure, as well as added cashflow potential (Exhibit 2). Some financing options are more accessible and easier to scale. Fund structure can also come into play, as a closed-end fund is likely to have a notably different leverage approach compared to an open-end fund, where additional capital needs are generally less of an issue. It is important to align the leverage strategy with the overall strategy of the fund and the risk profile of the underlying assets.
How Can Investors Better Evaluate the Use of Leverage in a Fund?
In addition to overall portfolio exposure, investors can gain a clearer picture of how leverage is employed in a fund and the related risk/reward considerations by understanding, both, how the manager accesses it and applies it.
Type of financing: Exhibit 3 highlights five main types of financing that managers can employ to gain leverage exposure. A leveraged fund may utilize one or several of these approaches.
Sourcing and terms: Who are the fund's financing providers, and how stable are they? What are the typical covenants required by the financing, and what events or circumstances will require a re-margin or trigger a default? What guaranties, if any, are required?
Applications: How does the fund manager incorporate leverage into its investment strategy? Does it align to the overall risk/return strategy of the fund? Is the leverage match-funded with the underlying loan made by the fund? Is the leverage cross-collateralized with other assets in the fund or are the loans structured as non-recourse protecting other assets in the fund?
What to Look for in a Manager
There are a number of attributes investors can consider to help evaluate a fund manager's ability to use leverage successfully and appropriately.
Experience: Does the manager have a proven track record of employing this approach through a range of market environments, particularly challenging periods? Does the fund manager apply a sound, logical leverage strategy that addresses risk and return?
Transparency: How transparent is the fund manager's leverage usage, and how is it reported?
Execution capabilities: Does the fund manager have consistent access to strong and diverse lending relationships? Is it well positioned to structure favorable covenant terms? How effective has it been in navigating loan workouts?
Liquidity: What is the manager's liquidity strategy to mitigate the risks associated with the various forms of leverage?
Assessing the fund manager's abilities in these areas can help gain insight into what potentially to expect in terms of leverage performance and risk exposure across market cycles.
Conclusion
Leverage can be a powerful strategy to enhance return in real estate debt funds. In certain instances, it can add to the risk profile of a fund, especially if higher amounts of leverage are utilized. The key is to understand why and how a fund manager is employing it in the portfolio to help make sure the approach is aligned with your investment objectives and risk/reward profile.
