How to Use Private Debt to Mitigate Real Estate Risks for Your Clients
Private real estate debt can produce reliable returns while helping investors minimize risk. Here’s what investment advisors should know.
Registered investment advisors (RIAs) and family offices are critically important in helping individuals, families, and others manage their wealth and find the right investments for their needs and goals. As advisors, they provide guidance on the potential for returns and the risks associated with different types of investments. They must understand their clients’ personal or business goals and carefully evaluate investment opportunities to see if they fit with those goals. Private real estate debt investments are low-risk compared to many other investments while offering the potential for consistent returns. This article offers guidance to RIAs and family offices on how real estate debt investments can be an effective way to mitigate risk in an investment portfolio.
What is private debt in real estate?
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Private real estate debt is a form of direct lending to real estate projects or developers. A lender, such as Capstone Capital Partners, raises money from investors to make hard money loans and bridge loans to borrowers. These borrowers might be developers, builders, or real estate investors working on fix-and-flips or other projects.
In traditional real estate equity investments, the investor owns all or part of a property, which means they are ultimately responsible for maintenance, taxes, insurance, and other obligations. They are also responsible for their exit strategy, such as selling the property for a profit or collecting revenue through rent.
A private real estate debt investor holds all or part of a lien on property. The property secures the loan obligation, and the lender manages all the aspects of servicing the loan. The investor receives passive returns in the form of interest payments. This can be a particularly attractive investment while interest rates remain relatively high.
Loan terms for private real estate debt are usually quite short, ranging from six months to two years. At the end of the loan term, the investor gets their principal back and can use it for more investments.
Capstone Capital Partners has two private real estate debt programs:
Capstone Growth Fund: Investors place their money into a fund used for hard money and bridge loans. The fund targets 10% returns.
Fractional real estate loans: Investors can take a more active approach by becoming the lender. They can review loan opportunities and choose where to put their money. Capstone vets the borrowers and originates and services the loans.
What are the key benefits of private debt in real estate?
Private real estate debt offers several benefits for accredited investors that can help them mitigate the risks in their portfolios.
Seniority in the capital stack mitigates risk.
Senior debt is higher than equity in a traditional capital stack. It has the highest priority for repayment in the event of default or other problems. Hard money loans are almost always first-lien debt. Bridge loans might be first- or second-lien.
Should a borrower default on their loan or declare bankruptcy, these loans have high priority for repayment. Secured debt is often the highest priority of any debt other than taxes. This gives debt investors greater protection than equity investors, who would have to wait for debts to be paid before recovering their investments.
Private debt offers fixed returns and stable income.
Many real estate investments can only offer projected returns, such as estimated rent revenue or future market value. Private debt investments pay returns in the form of interest payments. These are determined at the beginning of the loan term. While default is always possible, debt investments offer far more stable, predictable returns and a steady income stream.
Private debt focuses on preserving capital.
Hard money lenders focus on the property that secures their loans. These properties ensure that their investors can recoup, at minimum, a significant part of their investments should a borrower default. This minimizes the risk of significant losses, making private real estate debt investment a safe bet compared to many other types of investments.
How do due diligence and risk assessment work for private debt?
Due diligence for private real estate debt investments begins with finding an experienced lender with a track record of successful loans. Capstone, for example, has funded more than $500 million in loans. We perform stringent due diligence before approving loan applications and originating loans. As a result, we have a low foreclosure rate, with only 2% of our loans going into foreclosure. This has allowed us to provide our investors with 8-10% returns.
Capstone uses multiple legal instruments and insurance policies to secure our loans and protect our investors’ capital:
Deeds of trust
Promissory notes
Loan servicing agreements
Hazard of home insurance
Title insurance
When evaluating borrowers, we consider many factors, including the following:
Property type and location
Market conditions
After-repair value of the property
Business plan and exit strategy
Loan-to-value ratio
Borrower’s experience and track record
Borrower’s creditworthiness
What are some practical steps for advisors to implement private debt strategies?
Investment advisors can add private real estate debt to their clients’ portfolios gradually if they want to get a sense of how the investment works and whether it fits with their clients’ goals. Capstone typically asks for a minimum investment of $100,000, but it may be possible for new investors to begin with a smaller amount.
Private debt investments can easily fit alongside other real estate investments in a portfolio. An investor could use private debt for steady income while also making equity investments, or they could use a private debt investment to supplement rent revenue.
Ongoing monitoring is important for investment advisors, who must report to their clients about how their investments are doing. Capstone makes this easy by providing investors with online access so they can check up on their investments.
Photo by Kane Taylor on Unsplash
Case study: Private debt’s role in a Texas real estate portfolio
Suppose an investor decides to become a lender in our fractional loan program. They research vetted and approved loans and decide to contribute $100,000 to a borrower who will be purchasing and rehabilitating a multifamily residential property.
The loan has a two-year term at 10% interest. It is an interest-only loan, with a balloon payment at the end of the term.
Their share of the monthly interest payment is $833.33, minus Capstone’s fee. They receive this amount every month for two years, for a total of $20,000. At the end of the loan term, they get their $100,000 back.
Learn more about private debt as part of a real estate investment strategy
Real estate debt investments can provide excellent returns with minimal risk. Capstone Capital Partners offers opportunities for Texas investors to access hyperlocal trust-deed and first-lien investments. Please contact the Capstone team today through our online contact form to learn more about what we can do for you.
