Real estate debt funds gained popularity during the 2008 financial crisis. Essentially, debt funds link borrowers, who tend to be developers, to short-term capital to finance their construction projects.
Real estate debt funds have in the recent past been experiencing rising interest from investors. The strong competition is leading to the rise of large debt funds grabbing a huge portion of the market share.
While real estate debt funds might be a small niche, they are quite profitable to investors. In this article, we get to the bottom of why they’re worth investing in and how you can earn consistent income from them. But first, what are they?
What Are Real Estate Debt Funds?
A real estate debt fund is a common resort for experienced real estate developers and investors. It gives them access to short-term capital for commercial real estate projects. The most common real estate projects where investors can use real estate debt funds include industrial buildings, multifamily units, and commercial construction projects.
In layman’s terms, real estate debt funds consist of capital supported by private equity and finances prospective real estate buyers or current owners.
If you invest in a real estate debt fund, you receive regular payments from the interest charged on the loans. Your payment is also sourced from the security that is levied against the property assets. This usually takes the form of a mortgage.
Borrowers normally use senior real estate assets as collateral to access funds for various commercial and real estate projects.
In most cases, real estate debt funds provide solutions for a particular investment idea or pursue a certain loan strategy. For example, some funds might focus on funding retail or shopping complexes, while others could solely be offering construction loans for residential projects, such as multifamily apartments. You might also come across other types of loans, such as hospitality, industrial, or vacant land.
Who Uses Debt Funds for Financing?
Real estate debt funds are common with people who don’t qualify for funding from traditional lenders. They also have friendlier terms compared to conventional lenders.
For these reasons, real estate debt funds tend to be popular with people in entangled financial situations or who can’t access conventional funding for some reasons.
The most common loan types in real estate debt funds include:
- Construction Loans
- Property Renovation/Redevelopment Loans
- Bridge Loans
How Do Investors Earn Through Real Estate Debt Funds?
Real estate debt funds are one way of investing passively in real estate. If you decide to invest in a real estate debt fund, your income will be generated through interest charged on the borrowed capital. Simply, you’ll earn more income from your investment if you levy a higher interest rate.
Your investment can also generate income in case the borrower defaults on payment. The real estate debt fund is entitled to the property used as collateral during the securing of the funds. If the borrower obtained the funding for a commercial building construction project, then the property becomes available to the fund when the borrower defaults.
Interest rates vary depending on the debt fund. However, the average interest rate is about 9%. The interest rate is usually spread out in monthly repayments. Besides, borrowers are required to cater for extra fees, such as:
- Service costs
- Exit costs
- Extension costs
- Origination costs
- Modification costs
In some instances, investors are given a portion or all of the extra fees that the borrowers are required to pay. However, this is dependent on the type of real estate debt fund that an investor decides to invest in.
When investing in a real estate debt fund, your first goal should be finding a suitable debt fund. Luckily, there are many of them to select from. Also, you don’t have to be involved in the managerial tasks involved with your investment unless you want to become a manager. Someone else is usually in charge of managing all the investments placed in the fund. This gives you the freedom to take a back seat and enjoy your income.
Investing in real estate debt funds is recommended for investors looking to balance their investment portfolios. They are a low-risk investment option, which allows you to lower your investment portfolio’s risk and earn a regular income as you wait for your higher-risk investments to pan out. Investing in riskier investment options increases the possibility of running losses. Real estate debt funds can help you hedge these losses.
What Are the Benefits of Investing in a Real Estate Debt Fund?
The primary advantage of investing in a real estate debt fund is consistent income and stable returns on investment. Payments are usually provided every month or every quarter.
It’s also suitable for investors who are looking to balance their high-risk investment portfolio and also for those sticking to low-risk investment options. All these are guaranteed as long as you partner with the right debt fund management firm.
Investing in a real estate debt fund is a great avenue for diversification because the capital is used in various projects at the same time. This means that if any particular project fails then you shouldn’t have to worry about losing a significant amount of money.