Investing Themes: Secured Debt Investments

Investors are constantly looking for ways to increase their returns while minimizing their risk.  Many investors have a portfolio allocation to fixed income securities like bonds, mortgage-backed securities (MBS), preferred equity, or notes.  These securities are mostly structured as loans to enterprises to perform a variety of business endeavors.  The purpose of these fixed income securities, from an investor perspective, is to provide stable and predictable cash flow to the investor. 

Historically, most fixed income investors have looked at the public markets for fixed income products like government issued securities or corporate debt.  However, there are ways to access fixed income securities in the private markets that can offer higher overall returns with similar, but not identical, risk profiles.  One of these options is secured debt investing in real estate.  What is secured debt investing?  Secured debt refers to a loan that is made to a borrower where a property is pledged as collateral to the lender.  When you purchase a home with a loan, the lender lends you the money and receives either a mortgage or a deed of trust as additional security above the borrower’s promise to repay the debt.

Secured debt investing can offer a lower risk profile than equity and loan amounts are usually based on a certain percentage of a property’s current or future value.  In the case of a default, the lender has the right to foreclose and sell the property to recover their loan. 

There are various loan types that investors consider participating in to gain exposure to secured debt investing, here are a few:

1. Fix & Flip Residential: Fix & Flip loans provide capital to real estate investors that are in the business of buying properties in poor condition and investing capital to rehabilitate the property.  Upon completion of the renovation, the investor then sells the property on the open market for a profit.  Benefits to this type of loan include a short term which allows for decent liquidity since they are typically paid off in 3-12 months.  Other risks include execution risk which is the risk that the borrower cannot complete their business plan or that their project goes over budget.  The other main issue to investing in these types of loans is reinvestment risk.  Upon repayment of the loan, you may not be able to find another loan to make with the same rate so the investor cash flow could be more unpredictable.
2. DSCR Loans: DSCR (Debt Service Coverage Ratio) loans are made to commercial borrowers that own small to mid-size residential rental properties and are typically longer-term loans.  The lender underwrites the loan amount such that a certain portion of the net operating income is available to service the debt.  In the case of a DSCR loan that is sized to a 1.25x, it means that for every $1.25 of net operating income coming from the property, $1.00 goes to repay the interest and principal of the debt.  Benefits to making these loans include a more stable cash flow profile since the debt payments are backed by the tenants in the property as well as the borrower.  Tenants usually sign ~1 year leases so the cash flow is more predictable.  DSCR loans have interest rate risk since they tend to be 5, 7, or 10 year terms.  If inflation increases during the hold period, the real return goes down if the rate is fixed.
3. Commercial Real Estate Bridge Loans: CRE bridge loans tend to offer a higher rate of return when compared to lending to a stabilized asset and also offer more risk.  The purpose of a bridge loan is similar to a Fix & Flip loan.  An investor is purchasing a property and executing a specific business plan to eventually sell the asset for a profit.  However, the main difference with commercial real estate bridge loans is that they tend to be longer term.  The loan terms range from 1-5 years depending on the underlying business plan.  Bridge loans command higher interest rates from borrowers so the net investor returns tend to be higher.  Execution risk is a major consideration with bridge loans as well as borrower credit quality.
4. Commercial Real Estate Stabilized Loans: CRE stabilized loans offer lower rates of return when compared to bridge and fix & flip loans.  The assets behind these loans tend to have stable operations and high credit quality borrowers.  Terms can range anywhere from 5 to 30 years depending on the asset type and borrower business plan.  The main benefit to lending to stabilized assets is the predictability of the cash flow to the lender and the lower risk profile.  However, risks still exist and it’s important to evaluate the underlying asset in great detail. 
5. Hard Money Loans: Hard money loans are a catch all category of private lenders providing loans to a variety of borrowers for a variety of reasons.  Hard money loans tend to be riskier loans at lower leverage points made by private lenders.  Hard money loans can be made against essentially any type of real estate asset and tend to be short term in nature (1-2 years).  In the current market, hard money lenders are lending against raw land, distressed assets, and hard to finance projects.  Most hard money lenders are highly sophisticated real estate investors that are acutely aware of all of the underlying risks.

There are several ways to access these types of investments.  Some investors choose to make loans direct to borrowers.  It takes a certain level of expertise to value a property, put the documents together, and manage the loan after it’s made.  Other investors prefer to invest in a fund managed by a professional lender that has expertise in underwriting and making loans.  For the average investor that is interested in secured debt investing it may make the most sense to invest in a fund structure where they have proper diversification and a professional team to administer the loans after they are made.  In a fund structure, there is likely more than one loan, so the capital is diversified amongst several assets.  We would also expect that the borrower base is also diversified, meaning there are several borrowers as opposed to just one, which also helps with diversification.

Secured debt investing involves loans made to borrowers with property as collateral, which increases the likelihood of repayment. This type of investing offers a lower risk profile compared to equity investments, with risks including execution risk, reinvestment risk, and interest rate risk. There are various types of secured debt investing options, such as Fix & Flip residential loans, which are short-term loans for property rehabilitation and resale; DSCR loans, which are long-term loans for rental properties backed by tenant income; CRE bridge loans, which offer higher returns and higher risks for commercial property business plans; CRE stabilized loans, which provide lower returns and lower risks for stable commercial properties; and hard money loans, which are short-term, higher risk loans for various real estate assets. Investors can access these loans either by direct lending or by investing in professionally managed funds, which offer diversification and expertise.