The Role of Debt Funds in Commercial Property Financing
For commercial real estate borrowers, debt funds often offer loans that banks can’t-- or won’t offer, including commercial construction loans, bridge loans/lease-up financing, and certain property rehabilitation and redevelopment loans. According to the Mortgage Bankers Association (MBA), debt funds originated nearly $70 in billion commercial real estate loans in 2018, around 10% of all CRE loans originated in that year. That’s more than twice the $32 billion of commercial mortgages originated by debt funds in 2016. While some debt funds are operated by private equity firms, others are available for investment by the general public. Much like commercial mortgage backed securities (CMBS), debt funds are generally organized into tranches based on the credit risk of various groups of loans.
Why Debt Fund Financing Has Become Increasingly Popular
Debt funds first became a popular source of commercial financing during the 2008 financial crisis, when banks were no longer able to offer commercial loans to many borrowers due to serious liquidity issues. As a result, private lenders saw an opportunity to profit from filling a much-needed market niche. While banks, CMBS, and agency lenders have long since returned to offering acquisition and refinancing loans for stabilized properties, many still do not offer construction loans or bridge loans-- and that’s where debt funds come in. Even if a commercial borrower can identify a suitable lender for their situation, debt funds can often move much faster than other lenders, which can be essential when time is a factor in closing a deal.
In addition, a boom in the market for collateralized loan obligations (CLOs), allows some debt fund firms to more easily securitize and sell their loans. In 2018, 19 companies issued nearly $15 billion of CLOs, nearly double the amount of CLOs issued in 2017.
How Debt Fund Loans Work for Commercial Construction Borrowers
Most debt fund construction loans are offered to borrowers at somewhat lower LTVs than comparable bank loans; for instance, while a bank may offer 70% LTV for a purchase loan, a debt fund may only offer 60% loan to cost (LTC) for commercial construction financing. In addition, just like most other kinds of construction loans (including construction financing for single-family homes), debt funds issue money to borrowers in multiple disbursements, with each disbursement being issued only after the previous stage of work on the property is complete. Since most debt fund loans are for commercial construction or rehabilitation, the average loan term is usually between 24 and 36 months, with interest rates generally ranging between 10-12%.
For larger construction loans (i.e. $30 million+), debt funds are often willing to increase leverage up to 80% LTC, as well as decrease interest rates to between 7-8%. On loans of this size, borrowers may be able to get lower rates by reducing leverage. Generally, these larger loans are relatively low risk, as far as construction lending goes, and simply do not fit in with the lending parameters of many commercial banks.
The Largest Debt Funds Closed Between 2008-2018
Traditionally, debt funds open during a specific period, during which loans are issued and pooled together in the fund. Afterward, the fund closes, continuing to provide income for investors, but no longer issuing new debt. To give you an idea of the size and major players in the debt fund space, we’ve included a list of the largest North America debt funds that closed between 2008-2018.
Broad Street Real Estate Credit Partners III: Created by investment banking giant Goldman Sachs, this debt fund has a size of $6.7 billion.
PIMCO Bravo Fund II: Operated by Pacific Investment Management Co. (PIMCO), this fund has a size of $5.5 billion.
Blackstone Real Estate Debt Strategies III: Created by The Blackstone Group, the largest alternative investment firm in the world, Blackstone Real Estate Debt Strategies III contains $4.5 billion of commercial debt.
Broad Street Real Estate Credit Partners II: Also issued by investment banking firm Goldman Sachs, this debt fund is slightly smaller than its larger counterpart, with a size of $4 billion.
AllianceBernstein Commercial Real Estate Debt Fund III: Created by NYC-based investment firm AllianceBernstein, AllianceBernstein Commercial Real Estate Debt Fund contains $3.1 billion in commercial debt.
While these funds are all currently closed, numerous debt funds are being created each year by large and mid-sized firms alike. And, though debt fund loans are mainly a tool for a very specific type of commercial real estate borrower, some companies are considering branching out, meaning that they could soon competing with banks for traditional commercial acquisitions and refinancing. In addition, increased competition between debt funds is leading to a reduction of spreads across the board. All this means that debt funds are an increasingly promising option for borrowers seeking commercial financing, especially those looking for construction and bridge loans for somewhat higher-risk properties.