Optimizing leverage in real estate investments using debt strategies

When interest rates are low, anyone can be a real estate investor. When the debt market is running on fumes following wave after wave of federal interest rate hikes, it’s a much different story. According to Chad Holden Sutton of multifamily investment firm Quattro Capital, “To mitigate the refinance jam, CRE owners must explore alternative financing options, focus on reducing debt burdens and consider capital injections through equity or subordinate debt.” Furthermore, they need to optimize their fundraising operations to ensure ideal outcomes regardless of what the market throws their way.

In this article we’ll give property investors and the advisors that serve them the information they need about creative real estate debt strategies: Why they’re needed, key tools to know, and next steps to take if you’re interested in capitalizing on flexible terms, great interest rates, and ultimately higher return profiles.

Why are creative debt strategies needed?

Once upon a time, investors could walk into a bank and easily get a cheap loan for their next investment property purchase. Today, those days are long gone. Modern investors need to be crafty and nimble when it comes to financing their properties or they’ll quickly find that they are unable to even find affordable debt in the first place. While interest rates are already down from their October 2023 peak, they may not be back to their all-time lows any time soon.

Beyond the necessity of finding more flexible lending solutions, failing to be crafty when it comes to debt financing means leaving money on the table. If an investor doesn’t consider all the creative strategies out there for leverage in real estate, they will wind up paying higher interest rates, leading to lower overall returns. When investors from coast to coast are competing to attract the attention of the same equity investors, every basis point counts.

Traditional debt strategies

Here’s a quick overview of the most common approaches to leveraging in real estate.

Conventional loans are your bread and butter mortgage instrument. The typical expectation for this type of loan is a down payment of 30% or more.

Agency loans are made by private lenders and then bought by Fannie Mae and Freddie Mac, the government-sponsored entities that underpin much of the nation’s mortgage market, or other government entities. These loans are typically available for hairy deals and rougher market conditions, and sometimes come with beneficial down payment requirements or interest rates, but often require adherence to additional underwriting standards.

Bridge loans typically feature short terms and higher interest rates, and allow a flexible solution to an immediate cash need, for instance locking down a desirable property before refinancing into a longer-term, cheaper loan.

CMBS (Commercial Mortgage-Backed Security) loans are offered by banks and other institutions and subsequently sold to secondary investors. This gives lenders the ability to offer lower interest rates and larger sizes to investors, but they frequently come with additional requirements and prepayment penalties.

Out of the box debt strategies for property investors

Beyond the loans listed above, a range of more creative solutions can be key to driving truly outstanding property investment performance.

Hard money loans are made by private investors and are frequently used for flipping projects and similar scenarios. They tend to have high interest rates but because the individual lender sets the underwriting standards, can be a good solution for challenging situations when other lenders aren’t able to help. Nevertheless, the high interest rates and short-term nature of these loans are often seen as making them particularly risky. If your remodel doesn’t go according to plan, hard money borrowers can find themselves in a tight situation.

Seller financing, where the property owner provides the loan (secured by the property itself), is an ideal strategy for investors looking to buy property with low down payments or interest rates. Finding sellers amenable to this strategy can be challenging, though. In many cases, it is “mom and pop” sellers that are most open to this option. It’s always possible to simply ask a seller whether they would consider providing financing, particularly in markets where buyers are few, but working with an experienced investment sales broker can be another effective way to broach the subject.

Preferred equity is a type of equity that functions in some ways like debt. They are typically repaid before the deal’s equity investors, and share in the profit generation of the asset – up to a capped return rate. This kind of equity can be used as a funding solution when true debt, like a mezzanine loan from a bank, would be too difficult or expensive to secure. By offering a specific expected annualized return rate, preferred equity preserves the upside potential of the true equity investors in addition to being a flexible tool to make up a funding gap.

Special note: Running your own debt fund

New investors are getting into the property business every week against a challenging traditional investment financing landscape. Successful investors may be interested in switching gears to launch their own debt funds, particularly if they have strong relationships and deep knowledge of a particular market, property type, or strategy. We recently released a full feature set on the Agora platform giving investors the tools they need to launch their own debt funds:

• Investment tracking at the portfolio, investor, and loan level
• Easily add and track new positions, promissory notes, and contributions
• Investment Portal access for borrowers, where they can view data, documents, and performance indicators
• Control debt terminology and language based on your preferences and strategy

Find out more about this new tool set here.

Next steps for nimble investors

Before jumping into any of these real estate debt strategies, property investors should first do their own research and talk to as many lenders and related professionals as possible.

First, investors should speak to a wide range of lenders and related advisors. The list of loans and tools above is far from exhaustive, and special programs may exist courtesy of local municipalities or banks. The only way to gain a full understanding of these options is for investors to perform their own research specific to their goals, context, and location.

Here’s a starting point for the types of professionals investors should plan to speak to:

• Representatives of banks and credit unions
• Debt brokers with firms like Berkadia or CBRE
• Investment sales brokers that may be able to recommend lesser-known programs
• Other investors in the area, to learn of any programs they used

We have a more thorough discussion of eligibility criteria for different loan types in this article here. If you’re looking for more information on preferred equity, this guide is a valuable resource. For more on affordable housing programs, many state and local housing agencies will offer their own lists of resources. This article is a useful primer.

Always get multiple loan quotes before settling on a lender. The more “standard” your property deal is, the more options you’ll have. Be sure to explore them thoroughly before committing to a long-term relationship with any financial institution, no matter how well-recommended or attractive their terms are.

In this article we provided a ground-level understanding of sophisticated, creative debt strategies for property investors and the advisors they work with. We covered a number of commonly-known debt instruments, more advanced strategies such as preferred equity, and explored first steps for property investors.

Investors face plenty of challenges when it comes to getting properties financed, from competing bidders to tough market conditions making debt hard to qualify for – or afford. With access to a wider range of leverage strategies in mind, investors can look at more properties, spend less on interest payments, and drive better returns across their entire portfolios.

Modified Date & Time : 26 Mar 2024, 11:21 am

Author

Logan Nagel

Real estate development and PropTech analyst, journalist and business developer. Commercial Observer journalist; Ex-Propmodo; drawing on a background in multifamily investment and brokerage. Passionate about biodiversity, better urban planning, and spaces with soul. Catch me in the PNW.

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