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Key Takeaways:
- The intersection of risk and reward drive individual investment decisions
- CRE lender can participate in real estate investment with minimal risk compared to the equity owner on title
- Lender often has personal recourse on borrower as well as right to foreclose on property
- Equity investors have a higher risk tolerance and thus (should) have a higher return premium
Given that real estate lenders do not participate in project upside (return above the agreed cost of debt), why do companies choose to lend at all? Why not simply invest the funds themselves? Why do some entities provide debt (loans) and others provide equity (cash/ownership)?
In the evaluation of this discussion post, I keep coming back to the intersection of risk and reward through real estate investment. We have repeatedly studied, and continue to see, the tolerance which some investors have for risk and how that tolerance drives their real estate investment choices. I see this concept of risk and reward as one of the primary drivers behind a bank’s decision to lend (debt) vs a principle’s decision to purchase (equity).
Through providing commercial real estate debt; a CRE lender can participate in real estate investment without taking on the same degree of inherent risk as does the borrower (equity provider) who is on title. While it is true that the lender does not, “Participate in the upside of a project”, it is also true that the lender does not equally participate in the downside of the same project. The lender can “Fence In” or control its risk exposure in the deal, to a higher extent than the equity investor. A debt provider will typically obtain a full-recourse, senior-position note, paired with a commercial mortgage, in return for the capital provided to the equity investor (owner on title). These two devices (note and mortgage), enable the lender to pursue the borrower directly as well as foreclose on the mortgage and take ownership of the property, in the event of borrower (equity provider) default on the loan. In this way, along with other terms and conditions of the note and mortgage, the lender can reduce their risk and increase the stability of their return.
The return may be limited and non-inclusive of the project upside, but it is also protected to a higher degree than the equity partner’s capital investment. I would also note that the decision to participate in CRE investment as a lender, as opposed to a borrower, releases the obligation to participate in property management (primary involvement is transactional). The concepts of specialization and use of time also play a role in this decision to lend vs own real estate.
Like the lender’s decision to direct their participation in CRE investment based on their risk tolerance; the sponsors and equity providers choose to use debt as leverage to reach their own risk/return target. Typically, the equity side will have a higher risk tolerance, and demand a higher return, than will the debt side of a transaction. It is this risk tolerance and return demand that mandates participation as an equity principle. The principle or sponsor can use debt as leverage to increase IRR (leveraged) over and above what they would make with unleveraged capital. The principles of positive financial leverage (when unleveraged IRR is greater than the cost of borrowing) allow the equity investor to realize a higher return through spreading their equity across multiple investments and using debt to fill in the gaps. With every action causes an equal and opposite reaction. The use of debt to “spread” equity across more investments will inherently increase risk to the equity as the use of debt increases the standard deviation (volatility) of the cash flow stream(s).
Although the use of debt will increase risk to the cash flow stream; I would also mention that the ability to spread equity into several investments (as opposed to pooling in 1 property as a 100% equity purchase), can help to reduce overall risk to the portfolio. If a sponsor can diversify the equity into different industries, this could be a hedge against risk posed by one economic sector.
The concepts of specialization, localized knowledge, and highest/best use of time also play a role in this decision to participate in the equity (ownership) side of real estate investment.
Questions?
Should you, or anyone that you know, have any questions related to this post, please do not hesitate to reach out via phone, email, or text. I am passionate about helping others along their real estate journey.
— Nick Schlekeway
