Why Your Middle-Market Real Estate Fund Needs a Debt Policy

At some point or another, you or your board of directors have all probably wrestled with the question of debt — how much to take on, how to structure the debt, when to refinance, etc. It’s often a crude practice, following a HIPPO method (Highest Paid Person’s Opinion). There’s clearly room for improvement in the way we decide how to use debt in real estate. However, I don’t often see a lot of dissatisfaction over current practices. For the last decade, times have been good, and rates have been so low that debt hasn’t been a problem — at least until very recently.

Not caring until it’s a problem is a pretty common practice in any business setting, and debt management in real estate is no different. Loans have blown up for a lot of operators in recent months, leaving many wishing they had done something different in the months and years leading up to the current tightening cycle.

Could it have been avoided? Jerome Powell was known as a semi-hawkish FOMC member, his appointment as Fed chair was just a ticking time bomb, right? Inflation data was ticking up for months in 2021, inflation doesn’t just go away on it own, we should have predicted this, right?

Sure, maybe we could have, but we’re in the real estate game, not the interest rate game. Our projects are investments, not pure gambles. If you want to avoid deals blowing up, we have to do it in such a way that the success or failure of a project isn’t predicated on timing the market.

Hazards of Debt

Anyone who’s been in the real estate game long enough knows all too well the hazards (read: risks) associated with debt. When times are good and cash is flowing, no one is too concerned. It’s not until it’s too late that most of us become concerned with how we’re financing an asset.

Debt is a tempting source of funds. It’s cheap (well, until very recently), it’s plentiful, and outside of the hairiest of deals, easy to find. Bond markets have been on a 40 year bull run, and within the last 15 years or so, floating rates have been at 0% more often than they haven’t. This has given most of us (myself included) lots of time to develop bad habits and act as if rates will be this low forever.

I think we all know intellectually that debt risk is long-term, but often act as if it’s a point decision at the transaction close. Regardless of whether you are fixed or floating — no one can escape the consequences. If you closed on a floating loan in 2020 or 2021 and didn’t hedge yourself, you’re feeling the pain, because you borrowed for the then-current environment. Borrowers trying to lock rates in now are also borrowing for the current environment, but risk getting pinched later if rates follow historical patterns and start falling back down.

This leads me to the conclusion that there needs to be a deterrent for borrowing only for the current environment. It’s probably an oversimplification to say that the debt decision is simply about securing a greater rate of return to investors, but that’s the heart of the issue. The risk of debt can be a fuzzy concept, because there are many types of risk that have to be managed, but the one we’re probably most concerned with is just running out of cash.

Conventional Approaches

There’s a few conventional approaches to debt policy and debt management, all of which have their faults. These are a good place to start however, since there’s probably something useful we can pull from each of these approaches.

See what other companies are doing. Particularly successful companies — how are they leveraging debt, and how can we emulate them? Unfortunately, this is a classic example of the bandwagon fallacy. Just because everyone else is doing it, doesn’t make it a smart play. In truth, the success you are trying to emulate from another successful company likely isn’t coming from their debt strategy. Many CRE operators succeed despite terrible debt strategies, not because of them.
Copy what you have done in the past. What got you here isn’t necessarily what’s going to get you to the next level. Yesterday’s debt market isn’t today’s market, and it won’t be tomorrow’s market either. In mid to late 2020, it was smart to fix as much of your long-term debt as possible, but now in late 2022, after the 10T yield has increased 7-fold from its all-time low, is that strategy still viable?
Refer to some ambiguous “best practice, “industry standard, or “common knowledge”. Everyone was following industry standards leading up to the financial crisis. Some struggling operators now were following best practices before they started feeling pressure from floating rates. In the next easing cycle, a lot of operators are going to get hit with massive prepayment penalties because it was common knowledge that rates were going up forever. In other words, be skeptical (especially of internet strangers giving debt strategy advice).

Why these approaches fail

These types of strategies (or more accurately, the lack thereof) end up falling apart for a few primary reasons. The first is that more often than not, debt is viewed more like a short-term decision. The risks are weighed in a very narrow range of outcomes. In 2020, would did any of you model in 1-month floating rates going from basically 0% to over 4% in just 2 years? I know I wasn’t.

Second, because the debt is treated as a short-term decision, it’s often only looked at on an asset-by-asset basis. The risk is considered limited to that asset, often because the risk is evaluated from an asset management perspective. Questions that are asked are those like, “what if my anchor tenant doesn’t renew?”, or “what if an increase in crime in this neighborhood increases my vacancy rate?”. I’m sure you, dear reader, are the exception to this (why else would you be reading a random blog post about debt management policies?), but many operators don’t consider the risk of the debt to the portfolio as a whole. If they do, the furthest they may go is making sure they spread out the maturity dates so all their debt doesn’t mature at the same time.

Lastly — and I’m as guilty of this as the next person — too often the only evidence considered for the efficacy of a strategy is the fact that it’s worked so far. Every company’s own experience with debt creates informal policies that leads them to repeating behaviors despite changes in debt markets and the overall operating environment. We focus all of our energies on asset management, while ignoring the risks of debt management.

This is Part 1 of the Debt Management Policy series

Next: A Better Approach To Debt Management

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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