Real Estate Debt Investing: Pros and Cons

by Rob Phillips, CPA

We know that investors all over the country look for real estate investments to diversify their protfolios from stocks, bonds, mutual funds, etc.

In this post, we look at five general indicators to ensure our investments provide an adequate margin of safety: FICO score, LTV ratio, ARV ratio, LTC ratio, and the Sponsor’s track record. The limits to these indicators will vary depending on the position of the loan. In other words, there will be deviations between the underwriting criteria for senior vs. mezzanine position loans.

As a result of the deviation, there are corresponding returns associated with each position. As was briefly discussed in the earlier posts, the senior position investors can typically expect a return between 8 – 9%. In turn, mezzanine position investors typically earn a return greater than 12%. Although senior and mezzanine positions share the same benefits of real estate debt investing, there are certain risks inherent with each.

Benefits of Real Estate Debt Investing

  1. Passive Investment. The most obvious benefit of investing in real estate debt – whether in a senior or mezzanine position – is the investor’s ability to invest in real estate without having to manage the property itself.
  2. Collateral. Trust deed investing carries the added benefit of being secured by tangible real property. As was discussed in the first part of this series, the collateral characteristic offered by Trust deeds is critical in providing investors a margin of safety. In the unfortunate event of the borrower failing to meet debt obligations, investors have the ability to foreclose on the property in order to recoup their investment, plus any interest accrual owed.
  3. Consistent Returns/ Cash Flow. Trust deed investing allows investors to realize consistent monthly interest payments on invested capital similar to a fixed-income investment. Payment isn’t dependent on rental income (as with an equity investment) but rather is an obligation of the borrower regardless of property performance. Accordingly, trust deeds offer more consistent returns with reliable monthly cash flow.
  4. Diversification. Trust deeds also give investors exposure to real estate and a method to diversify their portfolios away from solely equities, such as stocks, and traditional fixed-income vehicles, such as bonds, without the added risks of property ownership. The investor is considered a lender rather than owner and in the case of senior position debt is in a last loss position.

Risks of Real Estate Debt Investing

  1. Interruption of Cash Flows. The largest risk to a trust deed investor is attributable to the Sponsor’s inability to make interest payments. In the worst case scenario, the Sponsor is unable to meet the property’s debt service which would not only result in an interruption of payments to the investors, but also a subsequent foreclosure of the property. And there is no guaranty that foreclosure proceeds will be sufficient to pay accrued interest and principal to investors.
  2. Property Devaluation. One of the most important factors in trust deed investing is the value of the property securing the loan. In general, a decline in real property value results in an increase in real estate default rates, causing the recovery rate of foreclosures to decrease. A large part of this risk can be mitigated by securing a trust deed investment with a sufficiently low LTV, thereby creating a larger cushion between the amount of the loan and the value of the property at the time the loan is originated.
  3. Lien Position. The position of trust deeds becomes important in the event of a foreclosure sale. Consequently, any subordinate position to the senior position carries extra risk as it receives lower priority in being paid out (i.e. a senior position lender will be paid first and whatever is left over (if anything) will be made available to the junior or mezzanine lender).

For any investor looking to diversify their portfolio in a straight-forward manner, trust deed investments are a viable option with consistent returns, reliable monthly cash flows, and a collateralized investment vehicle backed by real, tangible property. 

Final Thoughts

At the end of the day, real estate debt investments have pros and cons. This is no different from other investment categories. Make sure that you consider the risks and the rewards and compare this asset class to other classes like stocks, bonds, mutual funds, etc.

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