How Real Estate Debt Can Help Build Alternative, Passive Income In This Market

In today’s ever-evolving real estate landscape, investors are met with a mix of optimism and skepticism.

There’s no denying the challenges and uncertainties that have clouded the real estate sector, but as we all know, opportunity can arise even during turmoil. In this post from our sponsor, there is a serious look into an intriguing avenue that might not be getting the attention it deserves: private real estate debt.

Before we look into the “what,” let’s address the “why” and “how.” To understand the potential of private real estate debt in today’s market, we need to examine both the drawbacks and the opportunities that characterize the current real estate markets.

These factors converge to present a potentially rare opportunity: private commercial real estate (CRE) debt investing. With higher interest rates, reduced availability of debt capital, and a changing investment landscape, alternative lenders may command premium rates for credit-worthy operators seeking financing for quality opportunities.

One such alternative lender is EquityMultiple, which focuses on providing passive income opportunities to accredited investors through fixed-rate investments in senior debt positions. In the current market conditions, this approach can offer investors stability and potential returns uncorrelated with public assets.

As we explore the possibilities of private real estate debt, remember the wisdom of diversification in finance—a concept that continues to hold true. In a world of changing markets, private real estate debt emerges as a compelling option for investors seeking alternative sources of income and returns. Let’s read on…

Let’s not sugar-coat it. Many investors are looking askance at the real estate sector these days. There’s plenty of talk of the “real estate doom loop.” The real estate crowdfunding space has been embroiled in negative press. As a wise reader of financial markets once said, “Buy when there’s blood in the streets, even if it’s your own.” Take a look under the hood, and there are attractive opportunities in commercial real estate private markets, even without getting bloody. Private real estate debt may be one such opportunity, flying under the radar amid sensationalist headlines about the sector. 

Before we get to the “what,” let’s address the “why” and “how.” How would we characterize today’s market, specifically as it relates to real estate private markets? 

The Bad:

• Interest rates have generally climbed steadily over the past 15 months, the most aggressive pace of contractionary monetary policy in 40 years. 
• Real estate values have fallen. Empty office buildings are the most visceral example. While single-family homes have retained value, multifamily has been hit hard: average valuations dropped 17% in 2022.
• With the cost of capital up and capital markets fluid, real estate operators aren’t doing much business. Following a record-breaking 2021, apartment building sales dropped 74% in Q1 ‘23, the most (on a quarterly basis) in 74 years.

The Good:

• Many economic indicators remain positive, not least of which job numbers. Despite interest rate hikes, hiring remains robust. While many economists predicted, in early 2023, a recession by the end of the year, the “soft landing” scenario feels increasingly more likely. 
• Single-family homes remain at elevated levels and market-rate housing remains drastically undersupplied across metros in the U.S. This isn’t good news for renters, but it is good news for real estate investors. There remains a supply/demand imbalance that favors investment in multifamily. 

The belt-tightening following the collapse of Silicon Valley Bank has spurred a credit crunch in mid-sized and regional banking sector, where middle-market real estate operators historically source a substantial portion of debt capital. This means that there is a supply/demand imbalance in capital markets: there is still a broad set of opportunities for middle-market real estate operators, but an emerging financing gap for operators looking to refinance or do new deals.

All these factors conspire to create a potentially once-in-a-cycle opportunity: private CRE debt investing. With rates up, debt capital less prevalent, and an emerging landscape for new investment opportunities, alternative lenders can potentially command higher rates for credit-worthy operators (borrowers) looking to finance quality opportunities at relatively conservative leverage.  

Let’s take the example of a real estate sponsor looking to finance the acquisition and improvement of a 50-unit apartment building in Phoenix, the fastest-growing metro area in the country with persistently strong market fundamentals. The sponsor’s total project cost is anticipated at $20M. In early 2022 (before rates began climbing) the sponsor might have been able to secure a loan at 4% up to $15M (75% LTC) from a regional bank, rounding out the rest of their capital stack ($5M0 via LP equity and their own capital. As of October ‘23 their same regional bank may only be willing to lend to 60% of project cost ($12M). Given the same equity sources of capital, the sponsor now has a $3M financing gap. Alternative lenders could address such a gap by lending at a premium to first mortgage rates, potentially even in the low teens. Given the demand drivers that remain in the market, this may still be an attractive opportunity given total finance costs (from the borrower’s perspective) as well as an attractive fixed rate of return for the lender.   

EquityMultiple is an example of an alternative lender who is stepping in to fill these financing gaps. The firm raises capital from a network of individual accredited investors (including a high proportion of doctors and others in medical fields) and lends to vetted real estate sponsors. In so doing, the platform brings passive income opportunities to self-directed investors: fixed-rate investments that also bring the benefit of securitization of commercial real estate assets. While the firm also offers JV equity and preferred equity opportunities, EquityMultiple has made private CRE debt a focus due to present market conditions, as delineated above. 

EquityMultiple’s Ascent Income Fund provides a potentially strong starting point for accredited investors. The Fund targets senior debt positions across a diversity of commercial real estate assets, with a $20K minimum entry point, bringing the following benefits: 

• A highly passive structure: the investment generates only one tax document and requires no active management on the part of the investor
• Target annual returns of 11-13% based on the blended rate of contractual returns of underlying debt positions
• Redemption options after one year with reinvestment options
• EquityMultiple’s usual rigorous due diligence on each asset included within the fund

After a historically bad 2022 for the classic 60/40 stocks/bonds construct, private real estate debt is an interesting option as investors settle into a new market paradigm. Private CRE debt not only potentially offers strong income but also returns potentially uncorrelated from public assets. As the late great Dr. Harry Markowitz concisely put it: “Diversification is the only free lunch in finance.” 

Diversification aside, private real estate debt may offer a unique and timely return profile. As Howard Marks put it recently, “Thanks to the changes over the last year and a half, investors today can get equity-like returns from investments in credit.”

All investments entail risk, including the risk of principal loss. EquityMultiple investments are open to accredited investors only. Please visit www.equitymultiple.com for a full list of risk disclosures. 

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