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From an early age, most people are taught that taking on too much debt is irresponsible and can result in financial ruin. Therefore, many people shy away from investing in real estate out of fear that they will become saddled with debt. This is a mental hurdle more than anything else. What these people may not realize is that most commercial real estate is, in fact, purchased using some degree of debt. Some would go so far as to argue that the ability to invest in real estate using debt is one of the reasons the asset class is so attractive.
In this article, we look at the pros and cons of using debt to finance commercial real estate investments.
Most debt gets a bad rap. It’s no wonder, then, that people are hesitant to take on 6- or 7-figure loans to purchase investment property.
In reality, not all debt is inherently bad. There is an important distinction to be made between “bad” debt and “good” debt. Real estate debt can be classified as either, depending on how it is utilized and by whom.
Debt is generally considered “bad” when it does not serve a purpose for helping to grow your business or investment portfolio. For example, someone who takes on significant debt to purchase a vacation home would be said to have taken on “bad” debt. The debt used to finance this property does not generate any income, and will be viewed as a liability on the investor’s financial record.}
Debt can also be considered “bad” when it comes at a premium or with significant strings attached. For example, a commercial real estate bridge loan that carries an 18% interest rate is considered worse debt than a fixed-rate loan made at 4%.
Excessive debt is also “bad” debt. In commercial real estate, one of an investor’s goals should be to maximize cash flow. Free cash flow is the amount of income generated after all expenses have been paid, including principal and interest payments on all outstanding real estate debt. Sometimes, an investor will take on too much debt relative to what the property is able to generate in income. In worst-case scenarios, if an investor does not have enough income to make their debt payments, the loan will go into default. When this happens, the investor risks losing the property to the lender. Situations like these can often be avoided by taking on less debt to prevent it from becoming bad debt.
Debt can be good when it is used thoughtfully, appropriately, and in moderation.
When debt is used to grow an investor’s real estate portfolio, it is generally considered “good” debt. This is especially true when modest levels of debt are used to finance a property. In commercial real estate, lenders will typically use what’s called a “loan to value” ratio to determine how much debt a property can support. More aggressive investors may look to buy properties with a high (e.g., 70-85%) LTV, whereas more conservative investors will seek to invest in properties with a low (e.g., 40-60%) LTV. The lower the LTV, the more likely the property will be to support the necessary principal and interest payments associated with that loan in the future.
Debt is especially “good” when loans are made at low-interest rates, with fixed terms, and amortized over a long period of time—say, 20 or 30 years. Debt is even better when the loans are considered “non-recourse”. This is when the debt is secured only by the asset the loan finances. In the event of default, the lender has no other recourse or ability to seize the borrower’s other assets. The borrower is not held personally liable for repaying any outstanding balance on the loan.
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“Leverage” is a commonly used term in commercial real estate investing. Leverage simply refers to the debt someone takes on to finance a property, including property acquisition and any future improvements.
Most commercial real estate investments are made using some degree of leverage. On occasion, an investor may acquire a property through an all-cash transaction. However, these situations generally occur when someone is investing in smaller-scale deals. As properties become more expensive, such as those that trade for millions of dollars, purchasing them with all cash becomes more cost-prohibitive.
There are situations in which an investment group may acquire a significant asset using only cash, but typically, this only occurs when an investor needs to move quickly and does not have time to arrange financing. Post-closing, the owner will then typically put some form of debt on the property as a way of maintaining their cash reserves.
Real estate debt instruments are tools that an individual or business can leverage for the purpose of obtaining the capital needed to finance a real estate deal.
The most common form of real estate debt instrument is a traditional bank loan. These are similar to the loans someone may obtain to purchase a residential property, but have specific nuances as they are carefully tailored to individual borrowers and deals. In general, commercial real estate loans are considered more complex than residential real estate loans.
Real estate bonds are fixed-income investments or loans that have been backed by real property, such as a commercial real estate asset. Those who invest in real estate bonds can generally expect to receive passive income through the dividends these bonds generate. Most property bonds are issued by sponsors and/or their construction companies looking to fund a development project during the construction phase.
Private debt funds, sometimes referred to as “lending clubs” or “lending funds,” are used to pool capital from institutional and high-net-worth investors interested in lending on a commercial real estate deal. The mortgages against these properties act as the security for the debt fund’s investors.
Most private debt funds are established by adept real estate professionals (e.g., asset managers) who then lend to sponsors that need debt to acquire, construct, or rehabilitate an asset. It is important that the debt fund manager have significant real estate experience because in the event of default, the fund will take control of the underlying property and will then need to oversee the development on behalf of the fund’s investors.
Private debt REITs are considered one form of private debt fund.
Syndicated debt is another type of commercial real estate debt instrument. Syndicated lending is multilateral lending that is originated, arranged, and structured by one or more commercial or investment banks and marketed to a group (or “syndicate”) of lenders. Syndicated debt allows banks and other investment entities to make partial investments in the debt needed to finance a deal.
This lowers each investors’ individual risk, but helps to aggregate the total debt needed for the transaction. For example, one lender might make 20% of the loan while four others make 10% investments. The syndicated loan is then administered by the lead arranger or loan originator.
Most commercial real estate loans fall into one of three categories: adjustable-rate mortgages, fixed-rate mortgages, and interest-only mortgages. ARMs and fixed-rate mortgages are structured similarly to their residential loan counterparts. Interest-only mortgages are unique to the commercial real estate industry.
Adjustable rate mortgages, or ARMs, are when a loan is made at a variable interest rate. That interest rate is set at the time the loan is made, but can then adjust upward or downward depending on market conditions. Most ARMs are structured to have a set interest rate for a period of time, either 5- or 10-years, for example, and then will begin to adjust after that period expires.
ARMs are generally made at lower interest rates than fixed-rate mortgages. The spread will usually range from 50 to 100 basis points. This makes them attractive to investors who only plan to own the property for a short period of time. For instance, if someone plans to acquire a property and intends to flip it within three years, then a 5/1 ARM would be appealing. They would benefit from a lower interest rate, which allows them to build equity in the property faster than if they were spending more on interest payments each month.
Fixed-rate mortgages are made at a specific interest rate that, as the name implies, is then fixed for the duration of the loan. There is a premium investors pay for the certainty associated with fixed-rate mortgages. These loans will usually be fixed at a rate 50 to 100 basis points higher than an adjustable or floating rate mortgage.
However, with interest rates nearing all-time lows in recent years, those who locked in fixed-rate mortgages are now benefitting from these low rates as inflation begins to rise.
Interest-only loans are when the borrower only pays the interest, not the principal, for a specific period of time (known as the “IO” period). After the IO period, the loan then converts to a fixed- or floating-rate loan based on the terms in the initial loan agreement. IO loans are frequently used in commercial real estate development projects, as they allow the borrower to maximize cash flow during the early years of ownership.
Ideally, the borrower will stabilize the property before the IO period expires and therefore, will have sufficient cash flow coming in to make both principal and interest payments when that time comes. The primary drawback to IO loans is that once the IO period ends, the loan payments will be larger than if the loan had begun to fully amortize from the start.
Leverage benefits real estate investors in many ways.
Unlike other assets, like stocks or bonds, that require an investor to pay for the full cost of the investment they are making, real estate investors can utilize leverage to offset their up-front and out of pocket costs. For example, someone who wants to buy a $10 million property may be able to do so using $7 million in debt and only $3 million in equity. For just $3 million, the investor now holds title to a $10 million asset. Compare this to someone who wants to buy $10 million worth of Google stock. That person will need the full $10 million, on hand, to make that investment.
Assuming the investment property cash flows nicely, the owner then benefits from tenants who pay down the mortgage each month. Over time, that $7 million loan is repaid using the rents and other income generated by the property. Eventually, the owner will own a $10 million asset free and clear, despite only having invested $3 million initially. That is the beauty of leverage.
Anyone who is considering investing with a real estate sponsor will want to be sure they understand that sponsor’s approach to leverage. Whether a sponsor employs leverage or not, and to what degree, is indicative of the sponsor’s risk tolerance. More conservative sponsors will generally employ less leverage (a lower LTV ratio) than those with a higher risk tolerance. This is not to say one approach is worse than the other, but it is important to understand either way nonetheless.
During an investor’s due diligence process, they will want to inquire as to how much leverage the sponsor intends to put on the property, the types of leverage they plan to use, and at what terms. Upon property stabilization, how will the sponsor approach leverage? Will they seek to refinance into a lower rate or better terms? Will they pursue a cash-out refinance, and if so, will that cash be returned to investors? These details will impact the returns an investor might expect to earn over the lifetime of the hold period.
Although “debt” is generally thought of as a liability, the debt used to finance commercial real estate deals can be extremely positive. Simply put, it’s a way of putting someone else’s money to work for you as you grow your investment portfolio.
Of course, there is a fine line between “good” debt and “bad” debt. Good debt can quickly become bad debt if an investor becomes too highly levered or mismanages an investment. It is important for investors to strike an appropriate balance between how much debt and equity is invested in each deal to ensure “good” debt continues as such despite potential hiccups or changing market conditions.
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