Study: Debt Management is the Secondary Driver to CRE Profitability
It’s official — there’s scientific evidence suggesting the Debt Management is a driver to CRE profitability. Not the driver, of course…
It’s official — there’s scientific evidence suggesting the Debt Management is a driver to CRE profitability. Not the driver, of course, that honor falls with asset management, but it’s a secondary driver that all CRE operators should pay attention to.
In their paper, “Does Debt Management Matter for REIT Returns?”, written by Feng, Miller, and Tirtiroglu, published in January 2022 by the The Journal of Real Estate Finance and Economics, the authors analyze the ROA and ROE of publicly traded REIT’s from 1989–2015. The authors built estimation models intended to measure the influence of both asset management and debt management on REIT returns using Bennett decomposition.
If you don’t know what any of that means, don’t worry, neither do I. Thankfully, the authors concluded their work by summarizing their findings — while asset management is the king of value creation in CRE, the evidence suggests that debt management is a secondary driver.
While the authors don’t offer to what degree debt management creates value (something they weren’t attempting to measure), their results probably aren’t surprising to you. After all, real estate is almost always a levered investment because leverage boosts returns (well, except for the last several months). Operators that employ effective debt management strategies will minimize risks while maximizing their ROE.
Debt Management Strategies
We’ve covered specific debt management strategies in previous posts, going as far as quantifying how some strategies can boost returns. Unfortunately, not all debt management practices involve cool spreadsheets that can wow your colleagues. Some of the most important ones are boring, day to day activities. Debt Management is about consistency, not intensity.
Use The Right Debt Management Tools
It’s important to use the right tools and adopt the right practices. Just because you can use a hammer to drive a screw into a piece of wood, doesn’t mean it’s the right tool, nor will it produce the most effective result.
Create a Debt Management Calendar
Ok, so you don’t need specialized software to do this, but you will need some discipline. Technical defaults can cost you thousands, often from just missing some critical deadline or reporting date. There’s a lot of dates to keep track of, and it’s easy for something to slip through the cracks. Fill out this calendar, with plenty of reminders, as soon as the loan closes and those dates are locked in.
Bookmarked and Abstracted Loan Docs
Take the time to abstract your loan docs. Preferably right after you close the loan when everything is fresh on your mind. Pull out all of the relevant information you need from your loan docs and organize that information so it’s easy to find. Then, make sure you go back and bookmark where in your loan docs you found that information. In a couple of years when it’s time to review that abstract, you (or the next person to fill in that role behind you) are going to want to review the loan docs again to verify the abstracted information. If that information isn’t bookmarked, then the abstract isn’t nearly as valuable. There are PDF bookmarking tools that can help make this a breeze.
Lender Compliance Practices
The moment a loan closes, create a lender compliance checklist, complete with deliverables and financial covenants. If the covenants include any sort of calculate values like DSCR or Debt Yield, set up a calculation workbook with all of the calculation steps already set up and ready to go. Identify the financial statements you’ll need to complete the calculation, and identify the accounts you need to include in the calculation. You want Lender Compliance to be a rinse and repeat process, not a discovery process. Lastly, create a set of financial covenant sensitivity metrics. How much does DSCR move for every 1% change in NOI? Does your debt service change if rates move? Is there some threshold where your debt service moves from a fixed rate to a calculated one? Do rate markets indicate that might become a problem in the future?
Debt Management Software
The most important aspect of debt management is just doing it — adopt the right practices in your organization. However, the right tool can help make sure these practices are done efficiently and accurately. There are software platforms that do exactly what I’ve outlined above (full disclosure: my day job is to build this type of software). The best-in-class versions of this kind of product also offer services to help you complete these tasks so you can focus on your own primary value generation tasks, or spend time on more complex debt management tasks like optimization.
Summary
The most important takeaway is that debt management is about consistency, not intensity. You can’t effectively manage a debt portfolio by working intensely on the problem once a year. You’re effective by using the right tools and following the right practices consistently to prevent surprises from occurring.
If you liked this article, consider following me and subscribing to email updates whenever I post an article. You can also follow me on Twitter or connect with me on LinkedIn.