by Laus M. Abdo
As investors continue to allocate a greater share of their portfolios to alternatives, what are the advantages of investing in commercial real estate?
Given the ongoing volatility in the stock market, investing in alternatives remains a potentially prudent strategy for investors looking to diversify and to limit exposure to stock market volatility. Alternatives, particularly real estate, generally have a low correlation with the stock and bond markets and further diversify portfolio risks.
When deciding to invest in alternatives, investors are faced with a number of different options such as hedge funds, venture capital, private equity, crypto currencies, commercial real estate and many other alternatives. I believe opportunity can be found within commercial real estate given that it is one of the largest sectors out of all the alternatives. There are numerous approaches to invest in commercial real estate depending on your risk tolerance. You can invest in core properties occupied with long-term credit tenants in major metropolitan markets – such high-quality core assets provide low to mid-single digit returns. If you are looking for more capital appreciation, you can invest in higher risk development projects that can generate returns in the low to mid-teens.
Real estate investments can be all equity or a combination of debt and equity. Both the debt and equity can also have multiple tiers such as preferred equity or mezzanine debt. This is what is referred to as the capital stack or cap-stack.
How does an investor choose between the multiple tiers of equity and debt?
Equity is best in early to mid-cycle conditions because prices still have a significant upside ahead and downside is limited. During mid- to late cycle conditions, real estate debt is an attractive place to invest because it often has somewhat of a downside cushion while generating current income.
One of the main advantages of investing in real estate debt, particularly first trust deeds, is that you are investing in the more secured portion of the capital stack. You get paid back before all other investors and are more secured from losses because you have the senior claim against the property. In the event of default, you are the most secured investor against the property and therefore have a higher prospect of recovering your investment.
Over the last 20 years, returns on commercial real estate debt have remained competitive with corporate bonds, stocks, and high yield municipal bonds, and at a lower volatility than all three asset classes. Allocating a portion of your capital to real estate debt can improve diversification and stability.
How can investors access these types of investments?
A great way to access commercial real estate debt investments is through private commercial real estate debt funds that specialize in making first trust deed loans. Focus on funds that provide attractive risk-adjusted returns and capital preservation. Additionally, look for funds where the managers have their own capital at risk and where their incentives are aligned with those of the investors.
Proper alignment of interests between manager and investors include: a manager who puts significant capital at risk alongside investors; having all loan origination points and fees go directly into the fund to be shared with all investors; and implementing performance-based fees. At Watt Funding, we ensure proper alignment of interests between manager and investor with our commercial bridge lending fund. Additionally, Management is the largest investor in the fund. Further, all origination points go into the Fund and are shared with investors, and management’s incentive comes from performance. We only profit share when we generate an excess return above our investors’ preferred return.
How do real estate debt funds make money and protect investor capital, especially in the event of an economic downturn?
The keys to a debt fund’s success lie in the following principles: originating the right projects in the markets where the lender has significant experience, knowledge, and investments with experienced sponsors; applying stringent underwriting standards; being judicious when structuring the financing; and focusing on capital preservation. At Watt Funding, these principles have been integral to the success of our commercial bridge lending fund. Given our parent company’s (Watt Companies) 73-year history, we have a thorough understanding of the markets we invest in and all our loans require approval from our Investment Committee. The Investment Committee is comprised of commercial real estate professionals who have a combined 240+ years of experience and are independent from those who originate the loans. We leverage our market intelligence and expertise to structure first trust deed loans designed to both benefit the borrower and protect our investors’ capital.
A well-run debt fund will also have controls in place to minimize losses, even in cases of default or an economic downturn. First, conservative underwriting standards and a rigorous analysis process are critical in avoiding losses. Second, a fund that primarily finances first trust deed loans can more easily recover from default by foreclosing and maximizing the value of the property. Third, debt funds that have low LTV’s have a significant equity cushion in case of downward pressure on valuations.
Finally, debt funds that have in-house commercial real estate development and property management capabilities are often even better shielded against loss from default or an economic downturn. When a loan goes into default, these funds can take over the property at a fraction of cost, manage the project, and potentially gain an even greater upside once the economy recovers. For example, Watt has over 150 dedicated professionals across multiple divisions and offices – we can rely on these resources in a collaborative working environment, giving us an edge over much of our competition. Given this in-house expertise, when we make first trust deed loans, we always evaluate worst-case scenarios and whether we could take over the project and earn an attractive return. While we are not a loan-to-own shop, we stand ready at any time. Since inception in 2016, we have never had a default or foreclosure. Our fund structure and firm expertise allow us to make loans with a focus on competitive risk-adjusted returns and capital preservation.
This article was originally published as part of Lido Consulting’s Winter 2020 newsletter.
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