Insights Article | November 16, 2022
Real Estate Debt: Downside Protection Amid Market Uncertainty
Investors often ask, “What could happen to my investment if property values decline as a result of a recession”? As the housing market starts to retreat and the predicted recession looms on the horizon, investors are grappling with how a market downturn may impact their private real estate debt investments.
Downside Risk Protection
Even in market downturns, private real estate credit has historically performed well amid market stress due to its noncorrelation to the gyrations associated with stocks and bonds.
Because private real estate credit is typically structured with principal safeguards if the price of property decreases to some degree, during a recession, portfolio managers of private debt investments implement techniques to mitigate the impact of potential losses, while preserving the longer term benefits of the investment.
In a real estate debt fund, portfolio managers make loans based on a number of factors including, the property type, borrower experience, property cash flow and loan-to-value ratio (LTV).
Protective Equity Cushion
So, how are private real estate credit funds structured in order to a more stable rate of return and also be a hedge against market volatility? While there are a number of risk-mitigating strategies that offer downside protection, as mentioned above implementing a protective equity cushion is one way to help safeguard investor capital.
A protective equity cushion exists when the borrower has “skin in the game”. The borrower have cash or equity to lose. Lower LTVs require more of the borrower’s equity in a transaction, offering more protection for the investor. However, what if the value of the property drops? How will that decline impact the investment? Risk mitigation starts when the loan is made anticipate and plan for any potential negative outcomes when originally making the loan.
Wilshire’s WFP Income Fund mitigates risk on its loan portfolio by requiring borrowers to have a greater equity in the property. A 65% weighted average LTV, means borrowers have 35% of their capital in the transaction – resulting in a 35% protective equity cushion for investors that helps buffer against downside risk, including declining property values and borrower repayment. That equity cushion reduces the investors probability of a loss and puts the borrower in the first-loss position.
For example, let’s say a property currently valued at $10 million falls by 15% in a recession, now worth $8.5 million. With a 65% LTV, there is still a 25% equity cushion embedded in the loan structure that helps protect the investor in the loan. The borrower’s equity is in a first loss position.
Loan Loss Reserve
Private credit funds often establish a loan loss reserve, by allocating a portion of the proceeds of the offering or income from the fund’s portfolio.
Serving as a rainy-day fund, the loan loss reserve adds another layer or protection and is designed to cover potential losses from non-performing loans and investments, helping to mitigate risk for investors.
1st Lien Position
In the event of a non-performing loan, capital structure matters in risk mitigation. It determines the priority of payments.
A senior secured debt position (or first lien) resides at the top of the priority of payment structure and is the safest place to be for an investor. In this top-tier placement, investors have greater protection, will have first claim on real property, and may experience lower loss exposure. On the other hand, common equity is placed at the lowest part of the priority of payment structure, with the highest risk of losing principal.
At Wilshire, the WFP Income Fund makes investments in first trust deeds and mortgages secured by seniors housing, healthcare real estate, multifamily, and commercial real estate. The deeds of trust and mortgages in first lien position help protect the investment by being at the top of the priority payment structure and collateralized by a hard asset—real estate.
In a time when market uncertainty remains high, managing risk has become increasingly important to investors today. With conservatively underwritten loan structures and strategies with downside risk protection, private real estate credit is an appealing and timely portfolio option. Further, by investing with an experienced fund manager, it plays a key role in mitigating risk, providing diversification, and generating stable income.