A Better Approach to Debt Management

This article is part of the Debt Policy Series. The first part of the series can be found here.

In our last post we covered why debt policies are needed and why conventional approaches tend to fail. An astute reader will note that most of these problems stem from the fact that bad debt management isn’t a problem most of the time. CRE is profitable enough to hide bad debt practices most of the time. It’s the black swan events (like J Powell & Co instituting the steepest tightening cycle in US History) that really open up the cracks and we suddenly starting hemorrhaging cash.

The approach I’m suggesting below, admittedly, are speculations of improvement based on my own observations. I’ve had the privilege of peering into the debt practices of many different firms, some very aggressive with debt and other very conservative. My own professional experiences in interest rate risk management will bias my point of view to prioritize interest rates as the primary concern managing the life of a debt portfolio, not just a transaction date decision (as it should be, IMHO). But always remember to be skeptical of unsolicited advice from internet strangers.

To accomplish our goals, we’ll first create quantifiable metrics so that we can create probabilities of risk around our debt portfolio.

Portfolio Level Debt Standards

The first step in creating a debt management policy is establishing borrowing standards at the highest level, be it a fund or your entire portfolio. These will be set based on the risk appetite and desired returns of the fund. We’ll accomplish these via a capitalization rate and debt service coverage standards that our total portfolio must meet.

Think about these standards in the same terms a lender might for a credit facility. In effect, you are lending yourself equity across a swath of assets — by what standards are you willing to lend that equity out? What sort of debt limits should you reasonably expect a pool of assets to perform within?

The primary motivation behind these standards is being able to answer questions around your company’s or fund’s ability to remain solvent.

What happens in the event all of our assets are devalued by 20%? Do you know if you could continue to borrow funds or issue additional equity to keep things afloat?
What happens if 20% of your revenue disappeared? Could you remain solvent? For how long could you weather the storm?

You should use past loosening and tightening cycles as a way to set a baseline for these standards. Just keep in mind that past recessions may not provide enough experience in weathering future recessions, and those past experiences should not represent your “extreme” scenarios.

Asset Level Debt Standards

This is intended to establish the sort of terms that are acceptable for different types and classes of assets, and the business plans for that asset. These cover things like:

When fixed vs floating debt can be used
Hedging requirements
Recourse
Etc

This is focused on that asset’s ability to prevent an event of default from being triggers, of that debt from negatively leveraging the asset, etc.

These standards should be based on a set of underwriting standards assuming certain interest rate, liquidity, and other capital markets conditions. It’s a good idea to use your past asset management habits as a basis for these sort of decisions. For example, if you tend to hold assets for an average of 3–5 years, why would you use long-term debt? If you’re refinancing a core portfolio asset that you will never, ever sell, why would you use short-term debt (outside of extraneous circumstances, of course)?

We’re creatures of habit, and our business plans are within our control, so our Asset Level Debt Standards should match those. You may have multiple standards depending on the asset or project type (i.e. is this a value-add or stabilized asset?).

Policies and Controls

The last thing beyond simply setting standards is implementing policies and controls to ensure those standards are met. The policy can be something as simple as a checklist to ensure that the debt meets the asset level standards, and that the appropriate modelling has been completed to ensure your fund/portfolio level standards can be met.

The second piece to put into place are controls. There are always exceptions to the rule, risks you may be willing to extend beyond your policy limits. The control should be the process and documentation needed to break the policy. You need to indicate who is able to approve new debt that doesn’t meet the company policies, and provide the rationale for why the increased risk is reasonable, especially if there are debt options that fit the policy standards.

The primary use of policies and controls are transparency and accountability. The last time you got bitten by a debt decision, be it debt service costs running away from you in the last several months, or a prepayment penalty blowing up a deal during the last loosening cycle, do you have any way of going back and seeing why that debt decision was made?

The most important part of this entire process is being able to go back and see if the predicament you’re in was completely unavoidable, or if there was something you could have done to prevent it. That’s how we get better and keep ourselves from repeating the same mistakes over and over again.

This is Part 2 of the Debt Management Policy series.

Next: Creating Portfolio Debt Standards

The Debt Management Policy is a short series of articles that provide the resources and materials for building and establishing Debt Management Policies for your own CRE firm.

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