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

In the dynamic real estate market of today, investors encounter a mixture of hope and doubt.

The real estate industry has undoubtedly faced difficulties and uncertainty, but as we all know, opportunities can still present themselves when things are chaotic. This post from our sponsor takes a close look at private real estate debt, an interesting topic that may not be receiving as much attention as it should.

Let us examine the “why” and “how” prior to delving into the “what.” We must look at both the opportunities and the disadvantages that come with the current real estate markets in order to comprehend the potential of private real estate debt.

When these elements come together, private commercial real estate (CRE) debt investing presents a potentially unique opportunity. In the current investment climate, when debt capital is scarcer and interest rates are higher, alternative lenders may be able to charge higher interest rates to creditworthy operators looking to finance high-caliber projects.

Equity Multiple is one such alternative lender that specializes in offering accredited investors alternatives for passive income through fixed-rate investments in senior debt positions. This strategy can provide investors with stability and possible returns that are unrelated to public assets in the current market environment.

As we investigate the potential of private real estate debt, keep in mind the timeless wisdom of financial diversification. Investors looking for alternate sources of income and returns find private real estate debt to be an attractive option in a world where markets are constantly changing. Continue reading.

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Let’s not mince words. These days, a lot of investors are wary about the real estate industry. The “real estate doom loop” is a topic of much discussion. There has been unfavorable coverage surrounding the real estate crowdfunding industry. You should always buy when there’s blood in the streets, even if it’s your own, as a sage financial markets reader once advised. Examine closely, and even without going to war, there are lucrative prospects in private commercial real estate marketplaces. One such possibility that goes unnoticed amidst sensationalist news about the industry is private real estate debt.

Let’s talk about the “why” and “how” before moving on to the “what.” In terms of private real estate markets, how would we describe the state of the market today?

The Negative:

Over the previous 15 months, interest rates have typically increased steadily—this is the most extreme contractionary monetary policy pace in 40 years.
The value of real estate has decreased. Office buildings that are empty are the most obvious example. Multifamily properties have suffered greatly: average valuations fell 17% in 2022, while single-family homes have held their value.
Real estate companies are struggling because finance markets are unstable and the cost of capital is rising. Apartment building sales fell 74% in Q1 ’23, the highest (quarterly) in 74 years, after setting a record in 2021.

The Positive:

Not the least of the several favorable economic indications are the job numbers. Hiring is still strong in spite of interest rate increases. Although many analysts had forecast a recession by year’s end in early 2023, the likelihood of a “soft landing” scenario is growing.
Single-family home prices are still high, and there is still a severe shortage of market-rate housing in American metropolises. For real estate investors, this is wonderful news, but it’s bad news for tenants. Investment in multifamily properties is still favored by the current supply and demand imbalance.

Middle-market real estate operators have historically sourced a significant amount of debt financing from mid-sized and regional banks, but the credit constraint that followed Silicon Valley Bank’s failure has exacerbated the situation. This indicates that the capital markets are experiencing an imbalance between supply and demand: middle-market real estate operators continue to have a wide range of opportunities, but there is a growing financing shortfall for those wishing to refinance or make new deals.

The combination of these elements offers a once-in-a-lifetime chance to invest in private CRE loans. Alternative lenders may be able to charge higher interest rates to creditworthy operators (borrowers) who want to fund high-quality projects at relatively low leverage since interest rates are rising, debt capital is becoming less common, and new investment opportunities are starting to appear in the market.

Consider the scenario of a real estate sponsor wishing to raise capital for the purchase and renovation of a fifty-unit apartment complex in Phoenix, Arizona, the nation’s fastest-growing metro area with consistently solid market fundamentals. The initiative will likely cost the sponsor $20 million in total. The sponsor may have been able to get a loan at 4% up to $15M (75% LTC) from a regional bank in early 2022 (before rates started to rise), filling the remaining $5M in their capital stack with LP equity and their own funds. This same regional bank might only be prepared to lend up to 60% of the project cost, or $12 million, as of October 23. With the same equity sources of money, the sponsor’s financing deficit has increased to $3 million. By offering loans at interest rates higher than those of a first mortgage, possibly even in the low teens, alternative lenders could close this gap. This could still be a desirable option given the market’s remaining demand drivers, overall financing expenses (as seen from the borrower’s point of view), and an alluring fixed rate of return for the lender.

One alternative lender that is stepping in to bridge these funding shortages is Equity Multiple. The company gathers money from a network of accredited individual investors, many of whom are doctors and other medical professionals, and lends to real estate sponsors who have undergone due diligence. By doing this, the platform provides self-directed investors with prospects for passive income in the form of fixed-rate investments that also profit from the securitization of commercial real estate assets. As previously mentioned, due to current market conditions, Equity Multiple has shifted its concentration to private CRE financing, however the company still offers JV equity and preferred equity alternatives.

For accredited investors, Equity Multiple’s Ascent Income Fund offers a potentially solid beginning point. With a $20K minimum entry point, the Fund pursues senior debt holdings across a variety of commercial real estate assets and offers the following advantages:

An extremely passive structure: the investment just produces one tax document and doesn’t need the investor to manage it actively.
Based on the combined rate of contractual returns of underlying debt holdings, target annual returns of 11–13% are set.
Options for redemption with reinvestment following a year
The customary thorough due diligence performed by Equity Multiple on every asset featured in the fund

As investors adjust to a new market paradigm, private real estate debt is an intriguing choice following a historically poor 2022 for the traditional 60/40 stocks/bonds design. In addition to potentially providing substantial revenue, private CRE loans may also yield returns that are unrelated to those of public assets. In the succinct words of the late, great Dr. Harry Markowitz, “Diversification is the only free lunch in finance.”

Apart from diversification, loans secured by real estate could provide a distinct and prompt return profile. As recently stated by Howard Marks, “Investors today can get equity-like returns from investments in credit due to the changes over the last year and a half.”