Private-equity debt funds have been an increasing option for borrowers because banks are required to be more cautious in lending under tighter bank regulations. There is increased demand for investors seeking to place their money in debt and equity funds focused on real estate.

Private-equity real estate debt financing is on the rise. Real Estate Report indicate that aggregate debt-focused target (or optimal) capital increased by 6.45 percent year over year as of January 2017, to $33 billion. 

Pension funds, endowments, foundations and other commercial real estate institutional investors are adding debt-focused funds to their real estate investment options to chase higher yields in a low-yield environment. This expanding private-equity landscape is creating additional financing options that can help commercial mortgage brokers better serve their clients.

This undersupply of capital from traditional lending sources, such as banks, has created an opportunity for private-equity funds to fill the void. Some banks are still involved in the private-equity space by providing warehouse credit facilities to private-equity funds for lending purposes. Most banks have reduced their exposure to construction lending in the past three years.

When banks extend credit to nonbank lenders, it is less risky than making loans directly to property owners. The private-equity funds take on the risk, protecting the bank from losses. Because private-equity funds generally have a higher cost of funds than banks, private-equity debt financing for long-term, stabilized, low-risk deals will not likely be the best solution. There are numerous circumstances, however, in which private-equity debt does make sense. 

Private-equity debt addresses a void in the market but is not cheap capital. Through debt financing, private-equity funds are filling a need that other traditional lenders are not willing to consider. 

Traditional lending sources tend to focus on conservative investments in traditional property types like stabilized retail, office, industrial and multifamily. When a property does not “fit the mold,” traditional lenders will pass or will offer very conservative terms. Many banks, for instance, will not lend on development deals, and the ones that will require a low loan-to-cost (LTC) ratio of 50 percent to 70 percent.

In comparison, private-equity debt will, in some instances, go close to a 100 percent LTC ratio. Private-equity deals will often involve construction development, value-add properties, lesser credit, secondary locations, opportunistic strategy, less-than-perfect borrowers and other factors deemed undesirable by traditional lenders.

Private-equity debt requires a higher interest rate than capital borrowed from traditional sources like banks, insurance companies, commercial mortgage-backed securities (CMBS) lenders and government agencies. Private-equity funds, however, can process loans quicker because of their less bureaucratic approval and underwriting process. 

In some cases, borrowers can close deals in fewer than 14 days. In many cases, for developers, the speed and certainty of closing can result in increased profitability even with the higher cost of capital, compared with the less-expensive bank capital offered by lenders who may not close the deal on time — creating a risk that the developers will lose their escrow deposit and upfront capital. 

Counts, Stephen, and Ralph Cram. "Private-Equity Debt Can Save the Day." Scotsman Guide. Accessed April 17, 2018. http://www.scotsmanguide.com/Commercial/Articles/2017/08/Private-Equity-Debt-Can-Save-the-Day/.