Is a Debt Fund Right for You?

By Senior WriterPublished On: February 8, 20229.6 min read

For many real estate investors, securing financing can be a bit of a challenge. Sometimes there are barriers to entry when it comes to traditional bank loans, or investors might need additional financing on top of a bank loan. For this reason, some investors will turn to debt funds, which can often be a safe, alternate method of commercial real estate financing.

After the financial crash of 2008, debt funds, a type of mutual fund, began to rise in popularity because of the many regulatory restrictions put on banks, said Matthew Rubin, Capital Markets Analyst at Lev.

In many cases, banks are “not able to lend like a debt fund because of the bureaucratic red tape they have surrounding them,” Rubin explained. “So after ‘08, it gave rise to this private money lending sector that didn’t have the strict regulations that banks have.”

Today debt funds continue to rise in popularity. In 2021, debt fund investments went up, matching their pre-pandemic volume.

What Is a Debt Fund?

A debt fund is a mutual fund that invests in fixed-interest securities such as government securities, treasury securities, debentures, corporate bonds, commercial papers and more. These funds are called “debt funds” because the issuers of these funds borrow money from lenders.

The term “debt fund,” said Charlie Zabriskie, a Managing Director at Trevian Capital, “is representative of a non-bank lender,” or “a private lender that fills a void in the market … [to] provide loans where banks and other conventional lenders can’t because of things like timing [or] speed of execution.”

Some characteristics of debt funds are that they come with varying maturity periods and either generate income periodically or at the time of maturity, and there is always a predetermined maturity date and interest that a buyer can earn once the fund matures. They also generate steady income, so they are beneficial for those looking for low-risk investments and those new to investing.

When it comes to real estate, a debt fund will consist of private equity-backed capital that lends money to buyers or owners of real estate. Investors receive payments for the interest charged against loaned capital and security charged against the assets. These payments constitute a mortgage. Different real estate debt funds might focus on investing in different types of properties, as well as different price ranges.

Why Seek Capital From Debt Funds?

Generally, investors turn to debt funds because they provide fewer barriers to entry than banks. As a result, the loans are usually more expensive. Or, if investors already have a bank loan, debt funds can be a good source of extra leverage.

One reason investors seek out debt funds, Zabriskie said, is “because you need to close more quickly than a bank can provide a loan. You’ve got 30 days or less to fund your deal — to either close or refinance your deal — and you just need someone to move quickly.”

Other reasons, Zabriskie added, include “partnership buyout, partnership dispute, liquidity issues with the sponsor, credit issues where they need to be rehabilitated to get back to a point where they can qualify for conventional financing.”

All of these scenarios create barriers when seeking out traditional bank loans, so debt funds offer an alternative solution. Debt funds also offer a bit more flexibility — when it comes to changes or mistakes — than bank loans do.

“When you close with a bank, if you don’t have the date signed or a signature on the right line, a bank will come back to you and make you redo the entire document,” Zabriskie said. “They’re so inflexible.”

In addition, a bank is “dealing with multiple layers of the credit committee,” Zabriskie continued. When the loan originator goes back to the committee with changes toward the end of the process, many times they either don’t want to have that conversation in the first place, or the committee may end up canceling the deal altogether.

“When we sign a deal,” Zabriskie said, referring to Trevian, “we expect that things will probably change.”

With debt funds, it’s much easier to make changes to the deal right up until the end.

Why Invest in Debt Funds?

Investing in debt funds provides consistent income and stable returns on investment, as they are typically considered lower risk than other types of mutual funds. Debt fund investing is often considered safer than investing in equity funds, falling under the “fixed income asset” category.

If you decide to invest in debt funds, you’ll receive payments, called distributions, every month or every quarter.

Debt Fund Risk

Debt funds charge higher interest rates than traditional bank loans, so one of the main risks is that you’re paying a higher price, Rubin noted.

Other than interest rate risks, some other risks investors should consider include credit risk and liquidity risk. Credit risk involves the possibility that the issuer of debt security doesn’t uphold their obligation to return the principle at the date of maturity. Liquidity risk is the possibility that the fund won’t have enough liquidity down the line. However, as a whole, debt funds are generally lower risk than other types of funds, making them a favorite for risk-averse investors.

What Are the Different Types of Debt Funds?

There are a few different types of debt funds to choose from, depending on your needs and objectives.

Hard Money Loan

One type of debt fund includes a hard money loan, “which is one end of the spectrum,” Rubin explained. Hard money loans are typically seen as a last resort loan, taken out for a short time to raise money quickly at a high cost. Hard money loans rely on collateral and not on an investor’s creditworthiness.

With a hard money loan, “if the business plan fails, they really have no problem taking the property back and foreclosing on it,” Rubin said.

Collateralized Loan Obligation (CLO)

On the other end of the spectrum is a CLO, “which is a securitized note,” Rubin said. A CLO is going to be much cheaper than a hard money loan. Securitization is the process of pooling assets into a marketable security.

“Let’s say hard money is in the 10% to 12% range, CLO can be in the 3% to 5% range,” Rubin said. “They’re much, much cheaper. They’re typically for cash-flowing assets that are value-add.”

While some debt funds are for ground-up construction, a CLO is not. CLOs are security backed by a pool of debt, such as corporate loans with low credit ratings or loans taken out by private equity firms for leveraged buyouts.

Most CLO debt funds also require borrowers to buy interest rate caps as an insurance policy, Zabriskie said. This requirement protects against interest rate increases and is an added expense for the borrower.

“Typically, a true CLO debt fund loan is pretty inflexible,” Zabriskie added. “If something goes wrong, or there’s a dip in occupancy, or there’s a drop in cash flow, depending on the different covenants, constraints and loan documents, it might throw the loan into default … because the debt funds are beholden to their bond holders who have bought those securities.”

In this scenario, Zabriskie said, there’s not much one can do in terms of problem-solving. The lenders need to make sure the securities remain intact, rather than focusing on the borrower and their business plan.

While CLO funds offer high proceeds and low rates, there are other factors for a borrower to consider. For instance, Zabriskie also noted that CLO debt funds take a longer time to process, and borrowers aren’t dealing directly with the debt fund, but rather with a third party servicer who is communicating on behalf of the debt fund.

Non-CLO

In between a CLO debt fund and a hard money loan is a middle-ground debt fund like Trevian. With middle-ground debt funds, the focus is usually on bridge loans, but some might also do ground-up construction as well.

These debt funds “are going to charge in between 4.5% to 8%, depending on the deal profile, asset class, leverage market, sponsorship, experience, net worth, liquidity, etc,” Rubin said.

Non-CLOs don’t close as quickly as hard money loans, but they close much more quickly than CLOs because the rules are not as strict in comparison.

Trevian is an example of a non-CLO debt fund, Zabriskie said, adding, “We don’t securitize our positions. We hold the loans on a balance sheet for the life of the loan. We service the loans in-house as well. We don’t have all those layers of structure in our loans.”

How to Evaluate the Best Debt Funds

There are a number of factors to consider when evaluating debt funds, but Rubin recommends, above all, to find an expert who can link you with the right debt fund for your needs.

“There’s a whole spectrum of debt funds,” Rubin said. “As someone who doesn’t know where to go and whether or not they qualify for bank financing, if they talk to someone who is an expert in the commercial real estate lending space like Lev, we’re able to steer them in the right direction.”

Aside from talking to an expert, though, some factors to consider include fund returns, fund history, financial ratios and expense ratios. When evaluating fund returns and fund history, it’s a good idea to look for long-term consistency with a debt fund. Look at the performance of a debt fund over a five or 10-year period, for instance.

Of course, past performance is not always indicative of future performance. You’ll also want to look at financial ratios and expense ratios. A lower expense ratio usually means a higher take-home return.

Even after looking at these factors, it’s still best to consult an expert, even if you have a direct relationship with a specific debt fund, Rubin said. “There’s always value to be added to know the entire market. Even though you have a good relationship [with a debt fund], maybe there’s a better option out there. You’re not going to know that unless you’re engaged with an intermediary.”

Debt Funds Can Be a Good Alternative to Traditional Bank Loans

For commercial real estate investors looking to secure funding without some of the barriers of traditional bank loans — or investors looking for additional funding on top of a bank loan — debt funds may be the way to go. However, be sure to talk to an expert that can help you figure out the best debt fund for your specific needs.

Debt Fund FAQs

Can you lose money in debt funds?

Although debt funds are typically low-risk investments, it is still possible to lose money in debt funds. When debt funds rose in popularity after 2008, rising interest rates in 2009 caused bond prices to slide, so some debt funds suffered losses. As inflation and interest rates rise, investors are more likely to lose money in debt funds with low returns.

How do debt funds make money?

Debt funds make most of their money through interest. The fund charges interest to borrowers at a higher rate than typical bank loans, and payments are made monthly. In addition, debt funds usually charge origination fees and exit fees of around 1%, Rubin said.

What’s the difference between a debt fund and an equity fund?

Mutual funds like debt funds and equity funds tend to invest in different types of financial instruments. While debt funds invest in forms of debt, like bonds and debentures, equity funds invest in shares of a listed company.

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