Which is a better investment for the serious real estate investor in 2023, real estate debt funds or single-asset debt investments?
Before we answer that question, let’s discuss what these two asset classes mean.
As you know, a debt investment is an investment in which an investor lends money to a borrower as opposed to an equity investment where the investor gives money to a business owner in exchange for shares in the business enterprise. A fund is a pool of assets. Therefore, a debt fund is a pool of lending assets. To narrow that further, a real estate debt fund is a pool of real estate loan investments.
A single-asset debt investment is an investment where the lender is investing in one asset as opposed to a pool of assets.
Now, back to the question: Which of these investment opportunities is best in 2023?
Pros and Cons of Single-Asset Debt Investments
Let’s begin with single-asset debt investments in the real estate asset class. These types of investments involve an investor loaning money to a builder, developer, fix-and-flip investor, or another type of real estate entrepreneur with the expectation of earning interest on the loan paid out over a pre-defined period. Since they are “single-asset” investments, the deals are for a single property. They can be for properties built from the ground up, rehabilitated or revitalized, raw land, or rental properties. They can be for commercial real estate or residential.
Benefits of Single-Asset Debt Investments
One benefit to single-asset debt investments is passive income. The investor receives ongoing payments in the form of interest that serves as ongoing income for the lender.
Single-asset debt investments also provide investors with monthly cash flow. Whether single-family, multi-family, commercial, residential, or a mix of properties in a single portfolio, each debt investment provides cash flow for the investor rather than tying up the investor’s capital in a long-term commitment.
Investment properties also serve as a means of diversifying an investor’s portfolio. An investor may invest in stocks, bonds, real estate, and other asset classes. Even within the real estate asset class, an investor may own cash flow properties in several different subclasses.
Real estate debt investments are often collateralized. That means the borrower puts something up as collateral against the loan and, in the case of default, the lender can take possession of the collateral. In some cases, the property loaned against is used as collateral. If the borrower defaults, the lender takes ownership of the property and can sell it, rent it out, or capitalize on it in other ways.
Risks of Single-Asset Real Estate Debt
There are three primary risks when investing in single-asset real estate debt instruments:
- The first type of risk is cash flow disruption. If the borrower cannot make payments on the loan, the lender loses the cash flow benefit. Worst case scenario, the lender will foreclose on the property and take possession of it, which gives the lender the ability to increase cash flow potential or attempt to regain the initial investment by selling the property.
- The second risk is property devaluation. If the real estate market declines during the period of the loan, the lender’s investment is devalued. This risk can be curbed by securing a property with a lower loan to-value.
- The third risk is one’s position in the capital stack. With multiple lenders, one’s position in the capital stack determines the level of one’s risk. For instance, a mezzanine lender must stand in line behind the original lender when receiving repayments.
Every type of real estate investment carries some risk. Some carry more risk than others. Single-asset debt investments are excellent investments in rising markets and strong rental markets. In uncertain market conditions or when real estate prices are in decline, they are less desirable for many investors.
Pros and Cons of Real Estate Debt Funds
Real estate debt funds have their own unique pros and cons, their own set of benefits and risks. In general, the benefits to debt funds in real estate investing are:
- Cash flow – Just like collecting rents or interest on real estate loans, debt funds pay out regular interest to investors with money in the pool. This allows the investor to manage monthly cash flow.
- Low volatility – Stock markets can rise and fall. In periods of economic uncertainty, they can rise and fall a lot. This built-in volatility is undesirable for a lot of investors. Real estate debt funds have lower volatility as interest collected on the properties within the fund is static and produce a steady flow of income for investors.
- High yield – Real estate debt fund investments often are high-yield investments. Bridge loans are riskier and therefore produce higher yields. In general, the higher the risk, the higher the potential yield.
- Liquidity – Because investors do not own the properties in a fund directly, these investments are more liquid than typical real estate investments. If you own a rental property, for instance, you can enjoy monthly cash flow from the property, but your initial investment is still tied to the property, and it takes longer to get out of that position. With a real estate fund, you can pull your money out at any time making it a much more liquid position.
- Diversification – Real estate debt funds have built-in portfolio diversification since there are typically several investments pooled together in one fund. Often, these funds expose investors to several real estate subclasses. For instance, a fund may contain single-family rental properties, multifamily properties, and commercial properties together in one pool. Investors can diversify their portfolios without having to enter multiple investment positions.
- Short-term exposure – These investments usually offer shorter term commitments for investor capital.
- Hedge against inflation – Real estate has historically been a good hedge against inflation. Investing in a real estate debt fund is a viable way of protecting wealth against the ravages of high inflation.
One of the biggest risks of investing in real estate debt funds during a period of high inflation is potential underperformance. Because inflation tends to eat away at the value of the dollar, rising consumer prices could mean devaluing assets within the fund. However, lower volatility, higher yields, and cash flow potential could offset that risk.
Debt fund returns may also rely on leveraged positions. Investors should examine how fund managers leverage assets within the fund to achieve higher returns.
Finally, unlike equity investments where investors may have insight into property-level decision making, real estate debt funds do not give investors a visual into leasing agreements, property management practices, construction processes, and project management matters. Investors must be careful to evaluate the mix of real estate assets within a fund to ensure that maximum benefits are achieved for the duration of the investment.
Take the Next Step in Private Lending
Whether interested in a real estate debt fund or a traditional real estate debt investment, learn more about increasing your returns and diversifying your portfolio through private lending.