Private Credit

Recourse for Lenders When Obligations Are Not Met

  • Recourse Definition: Legal action or means to recover payments or repayment obligations that have not been fulfilled.

Real Estate Loans

  • Loan Collateral: Typically tied to the underlying property.

  • Guarantors: Individuals or entities that agree to fulfill the loan obligations if the borrower defaults. They may cover a specific percentage of the loan if the borrower cannot repay.

  • Rate Caps: A derivative instrument that can be purchased to limit the amount that floating rate debt can rise. This protects lenders from exceeding agreed-upon repayment amounts.

  • LTV and LTC:

    • LTV (Loan-To-Value): Measure of the loan amount divided by the appraised value of the property.

    • LTC (Loan-To-Cost): Measure of the loan amount against the total costs of completing a project, including acquisition and development costs.

Debt Yield and Minimum Debt Yields

  • Minimum Debt Yield: A threshold that assets must produce in return on a loan, calculated after a certain period. If this return is not achieved, the lender may consider the loan in default.

Cross-Collateralization

  • Definition: Using multiple assets to secure a loan, which means if one asset defaults, it can affect the entire portfolio secured by the loan.

Equity Pledges

  • Definition: Lenders may have the right to foreclose on equity in a property as collateral. This means lenders can pursue ownership of the financial interests rather than the physical asset in case of non-payment.

Management of Risk by Lenders

  • Preventative Mindset: Lenders operate with the consideration of potential default and employ strategies to mitigate risks before they arise.

  • Principle of Not Wanting to Own Assets: Good lenders prefer not to take possession of the asset through foreclosure, as it signifies a failure of the lending model.

Types of Credit Products

  • Senior Loans: Also known as first mortgages; the most common type of loan in real estate.

  • Mezzanine Loans: Subordinate debt that is secondary to senior loans, providing additional capital and risk.

  • Structured Equity: A form of equity that does not entail a direct claim on the asset, instead used to protect capital in complex financing structures.

Key Metrics for Senior Loans

  1. Debt Service Coverage Ratio (DSCR): A measurement of cash flow available to pay current debt obligations.

    • Calculation: extDSCR=racextNOIextTotalDebtServiceext{DSCR} = rac{ ext{NOI}}{ ext{Total Debt Service}}

    • Typical Requirements: Lenders aim for a DSCR of at least 1.2, meaning net operating income (NOI) covers 120% of total debt service, with a 20% margin before payment difficulties arise.

  2. Debt Yield: A measure of risk versus return for lenders; calculated by dividing NOI by total loan amount.

    • Understanding Debt Yield: Similar to a cap rate; lenders seek a debt yield that offers a premium over market cap rates.

    • Goal: If market cap rates are 6%, lenders target a debt yield of 8% or higher to maintain a safety margin in case of foreclosure.

  3. Loan-To-Value Ratio (LTV): The ratio of the loan amount to the value of the property.

    • Typical Limits: Good practices dictate a maximum LTV of about 65%, sometimes extending to 70% in competitive markets.

    • Purpose: Ensure asset value retention and capital preservation in a downturn.

Lender Types

  • Common Providers: Banks, life insurance companies, agency lenders (Fannie Mae, Freddie Mac), and CMBS lenders are typically involved in senior loans.

Underwriting a Credit Deal

  • Sponsors typically have more aggressive UW than lenders - Sponsors invest to realize upside, lenders work to limit downside, which is reflected in the UW

  • Lenders typically defer to market rate vs in-place, specifically around revenue assumptions and value metrics

  • Lenders UW is an art, not a science, as it must be conservative enough to limitdownside but aggressive enough to be competitive

  • Different asset classes and different markets will have different underwriting parameters and hurdles per a lender’s credit policy, where deals have gone poorly

5 Cs

  • Character:

  • Capacity:

  • Capital:

  • Collateral:

  • Conditions: Help protect yourself if something goes wrong

Credit Returns

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CRE allows investors to get exposure to the asset class while still protecting their downside and maintaining a controlling position within the capital stack

Through creativity financing, credit investors can manufacture outsized returns and retain liquidity

Credit investment (i.e., “paper”) is much more liquid than a CRE asset

Creative lenders can create credit products that achieve equity