Real Estate Debt: The Elephant in the Room

As many of you are aware who have invested in real estate syndication deals over the last few years, real estate debt can make or break a deal, and it is, by many estimations, the highest risk point within any syndication deal. Much of the headlines we hear in the news of late regarding deals gone bad are either due to an unscrupulous sponsor or variable real estate debt (Bridge Debt) that, in this environment of rapid and sustained interest rate hikes, can truly sink a deal. This has occurred because of variables that we have touched on in the past, and we will discuss in more detail below, such as variable rates, bridge debt, interest rate caps, etc. For those unfamiliar with some of the terms below and the basics, we recommend starting with our free eBook, which will give you a foundation of knowledge on which to build. Then, over time, each of our blog articles will get more granular to solidify your knowledge in a particular category. Our first discussion will delve into key aspects and a deep dive when evaluating debt in a real estate syndication deal.

Understand the Debt Structure:

Review the syndication’s offering documents, including the private placement memorandum (PPM) and operating agreement, to understand the structure of the real estate debt. Identify the type of debt used, such as traditional fixed rate debt, variable or bridge loan, floating rate debt, mezzanine loan, or seller financing. Is the loan an “Agency Loan,” better known as a Fannie or Freddie Mac loan, as these are usually more conservative in underwriting criteria and require extra scrutiny on the property risk and loan terms such as DSCR and LTV, as discussed below? In addition, be sure the real estate debt is a non-recourse loan, which does not allow the lender to pursue anything other than the collateral, in this case, the property. Although not specifically related to debt, but worth mentioning, nevertheless, a big picture item we like to look at is the delta between the going-in interest rate vs. the going-in cap rate of the deal. For the deal to pencil, the interest rate should be LOWER than the cap rate at the time of purchase. Fundamentally, although admittedly, there are nuances and exceptions to these rules if the cap rate is below the interest rate, it is a negative cash flow deal. These deals with a higher interest rate at purchase than the going-in cap rate are called a “Negative Leverage Deal” and are a higher risk proposition at the start. A creative accounting way that some sponsors illustrate this is looking at the theoretical “stabilized cap rate” as opposed to going in cap rate at the time of purchase, which often is a projection after the value-add plan is implemented but is less predictable when evaluating a deal as a conservative investor.

Analyze Loan Terms:

Examine the loan terms, including the interest rate, term length, amortization schedule, and any prepayment penalties. Prepayment penalties or “Yield Maintenance” are most common when using a fixed rate real estate debt in that if the property is sold sooner than the expected loan term or refinanced, the lender still gets their money. Although, for those looking to mitigate risk, a fixed-rate loan, at least for some time, is the preferred real estate debt in a rising or high-interest rate environment, the prepayment penalty is a crucial component to understand in these deals and can make selling early very difficult if it is onerous. Ideally, we like to see a deal pencil that is using fixed rate real estate debt and can also possibly pay down the prepayment penalty or have a tiered structure where the prepayment decreases to a minimum after three years.

Assess Loan to Value Ratio (LTV) and Loan to Cost (LTC):

Loan-to-Value (LTV), in simple terms, is the percentage of the property’s value financed with real estate debt. Lower LTV ratios generally indicate lower risk. Loan-to-Cost (LTC) ratio is the percentage of the project cost financed with real estate debt. LTC is similar to the LTV but considers development or renovation costs.

A higher LTC ratio may indicate more leverage and higher risk, so assess whether it’s within acceptable limits.

Real estate debt to cost is a more accurate metric in value-added deals where renovations are planned. Generally, we like to see deals in this and most markets with LTV less than 65%. A lower LTV/LTC gives the project flexibility if there is a need to refinance during the project and added options. Other variables to look at are whether there are multiple investor classes, preferred equity, or the presence of mezzanine debt in the deal. Depending on the percentage of investors in each class or the amount of mezz/pref debt, this percentage should be added to the LTV/LTC when looking at a deal risk profile from the limited partner perspective.

Assess Debt Service Coverage Ratio (DSCR):

Calculate the Debt Service Coverage Ratio, which is the property’s net operating income (NOI) divided by the annual real estate debt payments. A DSCR above 1.0 indicates that the property generates enough income or cash flow to cover real estate debt payments. Many deals we consider should have a DSCR in the 1.25 or greater range, but in all honesty, these days, as conservative limited partner investors, we like to see a DSCR closer to 1.4 or greater if fixed rate and >1.5 if an interest-only loan. Having said that, this may lead to us passing on many deals, but we are okay with that in this current volatile and precarious interest rate environment.

Unrelated Business Income Tax

Evaluate Loan Amortization:

You’ll want to understand the amortization schedule of the real estate debt, which details how the loan balance decreases over time. Longer amortization schedules may result in lower monthly payments but can increase the total interest paid over the life of the loan. Is the real estate debt an “interest only loan” for a period of time, as this can give sponsors some runway to enact value-add plans but might increase risk profile down the road?

Consider Interest Rate Risk:

Evaluate the interest rate risk by assessing whether the loan has a fixed or variable interest rate. We will go into more detail and nuance in this section due to its importance, so buckle up. We discussed this in prior sections, but variable-rate real estate debt can and have exposed investors and sponsors to fluctuations in interest costs, potentially affecting cash flow. The preponderance of bridge debt usage over the last few years by many sponsors at that time made sense, as the cost of this real estate debt is generally cheaper than fixed-rate real estate debt and does not have a prepayment penalty, which can also be called “Yield Maintenance.” In a low or stable interest rate environment, this type of real estate debt made sense for the sake of increasing returns and keeping flexibility for these deals looking to renovate and flip a large multifamily apartment. However, these loan terms, if interest rates change, increase the risk substantially as we are seeing signs of this already, and will likely get worse over the next 6-18 months.

If one has a variable loan or a bridge loan, the key is purchasing what’s called an interest rate cap, and the cost of these caps is now 10X or even more what they used to be. Depending on the value of the property and the time frame of the cap, several years ago, these rate cap costs were in the low hundred thousand range, whereas now many of those same caps are in the several million range. Consider these interest rate caps as an insurance policy that prevents the interest rate from going above a certain point, sort of a backstop. Many of these rate cap costs are not fixed, and unfortunately, in many of these recent deals, caps are set to expire over the next 12-18 months. Thus, when underwriting a deal, one cannot always anticipate what the rate cap cost will be several years down the road without knowing the interest rate environment at that time. In addition, many lenders require an escrow for the rate cap cost, and even if the rate has not yet expired, the escrow cost for the rate cap has now ballooned and eats into the property NOI creating stress for the property and cutting into cash flow. Many sponsors’ deals will become negative cash flow based on the variables above, and will be forced to figure out a creative escape strategy for these deals. Sponsors may try to expedite the value-add timeline to increase NOI in response to these real estate debt costs, but this is not always possible when cash is thin. Some options include a capital call to investors, reaching into their own pocket as sponsors, getting distressed real estate debt or a loan to try to ride this out, extending the rate cap, selling the distressed property at break-even, or possibly even a loss. Regarding a refinance, many deals with negative cash flow would need to bring money to the table to refinance and qualify for the loan criteria with the requirement of a lower LTV, thus increasing the DSCR.

Understanding this category as a limited partner cannot be emphasized enough, and you need to be comfortable with the real estate debt and these dynamics before evaluating and investing in any deal.

Assess Debt Covenants:

Examine any real estate debt covenants or requirements imposed by the lender. These may include financial reporting, property maintenance, and reserve requirements. Ensure the syndication can meet these requirements without undue strain on property cash flow.

Stress Test the Debt:

Ask the sponsor for details concerning the real estate debt stress tests or sensitivity analysis by analyzing how changes in interest rates, vacancy rates, or other factors might impact the property’s ability to meet debt obligations. Have they performed a stress test, if a variable rate deal, on the rate cap costs and escrow requirements? Consider worst-case scenarios to assess the syndication’s resilience to economic downturns.

Understand Exit Strategies:

Review the syndication’s exit strategy and how it relates to the real estate debt. Does the debt match the exit strategy, for example, is this a value-add deal with a 3–5-year hold that is focused more on upside or appreciation? Conversely, is this more of a longer-term deal, such as a 7-10-year hold time that is more of a stabilized cash-flow play? Be sure the real estate debt matches that business plan, and the sponsor has a good grasp of this alignment and strategy. Understand whether the plan for the real estate debt to be paid off will be through property sale, refinancing, or other means.

Compare Multiple Syndications:

We are here to help you with this to get a better idea of the target metrics in this current economic environment, and tools we have, such as the LP Deal Analyzer, are continually being updated to reflect the market dynamics. However, if you are considering multiple real estate debt syndication opportunities, comparing the debt terms, risk factors, and potential returns of several syndications can be used to make a more informed investment decision.

Conclusion:

Evaluating real estate debt in a real estate syndication requires carefully analyzing the terms, risks, and potential impact on the investment’s financial performance. Real estate debt plays a significant role in real estate syndications as it can affect the potential returns and risk profile of the investment. In many estimations, it is the one variable that could sink a deal or lead to a loss of capital. Make sure to perform proper due diligence, educate yourself, and when unsure, don’t be afraid to ask sponsors for clarification or explanation on components of the deal. Unfortunately, depending on the transparency of the sponsor, many of these terms and parameters, as outlined above, may not be spelled out and thus often require a separate email or conversation with the sponsor or the investor relations representative. If they don’t know the answers or don’t seem to have a good grasp or understanding of the above components, that in and of itself is telling.

You are not alone in this journey, and we are here to help with this education process and to help you make a more informed decision. Our website and its tools are for you to understand the potential risk points in deals and then decide for yourself as to whether it meets your investing criteria. This education and its utility are to allow you, the investor, the ability to make a more informed decision and to take that first step on your path to financial freedom. Let’s take this journey together…