The opportunity has arisen as a consequence of the recent tightening in bank lending criteria towards the property sector which has been undiscriminating, with little regard to individual developers’ track record or the quality of underlying projects. This has created a temporary dislocation in the traditional property financing market and an ideal opportunity for investors to generate attractive risk-adjusted returns.
Senior debt is a class of debt that has priority with respect to interest and principal over other classes of debt and over all classes of equity by the same issuer. In real estate, in the event of liquidation of the borrower’s assets, holders of senior debt will have a priority claim and get paid out first. Senior debt in real estate has previously been the domain of banks and because senior debt has the most secure claim over the asset, it is less risky from the point of view of the lender and it pays a lower rate of interest compared with debt of the same issuer having a subordinate claim or the projected returns for equity investors.
When a real estate project requires funds, debt and equity are the two main sources available to a developer. Each project will have its own breakdown of the amount and type of each, subject to negotiations between developer and investors.
Here is a simple explanation of the capital stack, which is what real estate investors use to “make up the funding” required to finance a project.
Below is the breakdown of how much, as a portion of total funding required, typically comes from the different types of debt and equity in a project.
Traditionally, banks take on the bulk of these senior loans due to the security offered by senior debt which typically includes the following:
- Senior debt registered as a 1st mortgage over the asset
- Personal guarantees from borrower
- Security over other assets of the borrower
There are other major factors for investors to consider when loaning in a senior position, which should include:
- The loan to value ratio (LTV)- the loan amount percentage in relation to the value of the underlying asset, the lower the LTV “the lower risk level” it is for the lender
- 3rd party verifications of the value of the assets – be sure to always see independent 3rd party verifications of financials and valuation reports
- Default trigger – under what situations will the borrower default and result in the lender taking over the asset and what is the time and process for this
- Loan term, principal and monthly repayment mechanism
- Exit strategy of borrower – critical so you have a defined term to your investment
Increasingly, banks are withdrawing from their traditional lending` markets. This is due to tightening regulations, greatly reducing the amount of senior loans available in the market. The Australian prudential regulation authority’s (APRA) has a growing fear of “less than prudent” lending practices by the major banks and this is a key reason why the banks are massively scaling back their real estate lending.
There may be nothing wrong with these developers or their development sites. As an example some of these senior debt loans have a LVR of 25%, which means to say, if the developer defaults on interest payments and loan terms, the investor can effectively step in and sell the property for a 75% discount before they would suffer any capital loses.
We believe that a well diversified investment portfolio to meet the investors risk reward profile should include a portion of senior debt positions and we are personally taking some positions in senior lending now, as we believe it is the safest direct real estate investment available in the market.
Here are some recent news articles relevant to the information above:
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