Diversifying your investment portfolio is a strategy that’s stood the test of time for good reason: It helps mitigate potential losses and presents opportunities for wealth growth over time.
Real estate credit investments offer a unique way to diversify, providing exposure to the real estate market without the burden of actively managing an investment property. Here’s how it works:
What is real estate credit investing?
Real estate credit investing involves providing funds to real estate assets through loans or debt securities for property transactions or development projects. In this type of investment, individuals or institutions act as lenders, extending financing to property developers or owners. The borrowers, in turn, commit to repaying the borrowed funds over a specified period, typically with interest. In the interim, the underlying asset serves as collateral, providing the investor additional security in the event of a downside scenario.
The world of real estate debt is vast, encompassing commercial and residential loans with varying structures and levels of complexity. Some common types of loans include:
Land loans
A land loan is used to finance the purchase of land. Depending on the state (permitting, zoning, etc.) and the land's intended use (residential or commercial), it can take various forms. Land loans are generally used if there isn’t an immediate need, plan, or ability to start developing an asset. Because of the speculative timeline for these loans and the lack of a cash-flowing asset to support them in the near future, they can be considered riskier.
Residential mortgages
Mortgages are long-term (typically 30 years) loans issued by banks or mortgage originators. The borrower repays in monthly installments until the loan is paid off, and the loan is either supported by rental income (if the house is used for investment purposes) or by the borrower’s income (if owner-occupied).
Commercial mortgages
Like residential mortgages, these loans facilitate the acquisition or refinancing of commercial assets, such as office buildings, industrial warehouses, retail centers, and hotels and resorts. The assets serve as collateral, and the income generated by them, such as tenant leases, covers debt service.
Often, these loans are packaged and tranched into commercial mortgage-backed securities (CMBS), which are issued and traded by financial institutions and can offer investors exposure to a diversified portfolio through a single security. The broader CMBS market provides liquidity to commercial real estate lenders by enabling them to offload mortgage debt from their balance sheets while offering investors an opportunity to invest indirectly in the commercial property market.
Construction loans
As the name implies, these loans finance the development or repositioning of new properties. Given that they are not supported by cash-flowing collateral, they are usually considered higher risk and command higher rates. Because of this high rate, borrowers will look to refinance the projects once they are complete and to capitalize their assets using more traditional, longer-term financing methods.
There are many offshoots of construction loans with different collateral structures, fixed or floating-rate interest rates, underlying asset qualifications, and other differentiators.
Private credit
Private credit refers to direct loans or financing provided by private lenders or institutions to entities such as real estate developers, typically bypassing traditional banking channels. Private credit can incorporate all of the four types of loans described above. For example, a short-term construction loan extended by a private lender to a multifamily complex developer. This form of lending enables borrowers to access capital outside conventional financial avenues, often tailored to specific project needs and with potentially more flexible terms than traditional bank loans.
The Arrived Real Estate Income Fund is a form of private credit. The fund invests in short-term loans to support ventures, such as property renovations, rehabs, or new home construction projects, overseen by experienced real estate practitioners. Residential properties back these loans, which typically span from 6 to 36 months and amount between $100,000 and $500,000. Investors in the fund can earn returns from interest payments on the loans, which are distributed monthly.
The benefits and challenges of investing in real estate credit
Investing in real estate credit offers several potential benefits for investors seeking income and diversification within their investment portfolios, like:
- Steady income stream: Real estate credit vehicles can provide a steady income stream through monthly payments.
- Diversification: Including real estate credit in a diversified investment portfolio can potentially contribute to risk mitigation.
- Secured investment: Real estate debt investments are typically secured by real collateral, meaning the underlying asset can be liquidated in a downside scenario, and investors can try to recoup their principal balance.
- Accessibility and liquidity: Real estate debt funds — like the Arrived Real Estate Income Fund — typically have lower entry barriers than direct real estate investments or private equity investments available only to accredited investors. Investors in these funds can also generally redeem their shares or units at predetermined intervals, providing a more flexible exit strategy.
Investing in real estate credit, while offering potential benefits, also comes with risks. For example:
- Default risk: There is a risk that borrowers may default on their loan obligations. Borrowers with significant experience in real estate development may pose a lower risk to mitigate this potential drawback.
- Market fluctuations: Real estate values can fluctuate with market conditions, affecting the collateral for the debt. A decline in property values may impact the recovery of funds in the event of default.
- Property-specific risks: The performance of real estate debt can be influenced by the underlying property's characteristics. Factors such as location, market demand, and property management can impact the investment’s success.
- Project execution risk: For transitional projects, such as construction or large rehab projects, there is always the possibility that the borrower may not be able to complete the project, thereby not fully improving the value of the underlying collateral due to factors such as cost overruns or labor issues. This risk can be mitigated by lending to creditworthy and experienced borrowers.
Loan evaluation criteria in real estate credit
Generally, real estate credit investments are evaluated for their investment potential and risks. Below are some of the most impactful factors impacting risks and investment potential:
- Borrower’s experience & creditworthiness: Borrowers are often ranked based on their years in the real estate industry, how many similar projects they’ve successfully completed, and if they work in real estate full or part-time. A borrower’s credit profile, including liquid reserves and their FICO credit score, is also considered. Generally, lower-risk borrowers have several years of experience in the field, have completed several similar-sized projects, and are well-capitalized.
- Loan to ARV (after-repair value): The loan-to-ARV ratio represents the proportion of the loan amount — including any additional property debt — to the estimated after-repair value (ARV) of the property, typically expressed as a percentage. This ratio includes the property appraisal from a qualified appraiser. A project with a lower LTARV generally has a higher likelihood of recovering its principal balance in the event of any downside scenarios.
- Loan position: Loans on a real estate project have different levels of standing in terms of both principal and interest payment. Loans in the first position are considered senior debt and have the first priority of repayment, resulting in lower risk potential for investors. (Learn more about the capital stack and the repayment priorities in What Is the Capital Stack?)
- Property location: Local market dynamics can significantly influence exit liquidity - whether via sale or refinancing - and the value of a property post-completion, with lower-risk projects typically situated in robust real estate markets.
In addition to the above four criteria, many other factors are considered when determining an individual loan's risk and return potential. For example, any additional collateral or guarantees that secure the loan, the project scope, and whether there are any prepayment penalties.
Investing in real estate credit vs. Investing in the Arrived Real Estate Income Fund
Investing in real estate credit on your own can take time and research. You need to evaluate opportunities, conduct due diligence, and track each investment over time.
The Arrived Real Estate Income Fund simplifies that process with a more streamlined, passive way to invest and the potential to earn monthly interest-based distributions.
A well-diversified portfolio can include both credit and equity. For investors looking to add real estate-backed credit alongside equity investments, the Arrived Real Estate Income Fund offers a simple way to gain exposure with a low minimum investment, regular reporting, and a structure designed to make private credit more accessible.
