Understanding the key terms used in real estate private credit

Real estate private credit (REPC) is increasingly popular today as an asset class. Private credit overall is growing, and REPC offers the additional benefit of real estate collateral backing every loan. Investors like the attractive returns profile, including the perceived lower volatility. In addition, many real estate investors are hesitant to buy or develop larger properties today given high construction costs and relatively high interest rates. Private credit offers another way to invest in real estate without tackling these challenges head-on (although many of our borrowers must still deal with them).

For this article, I wanted to help demystify real estate private credit, and introduce some of the terms I consider foundational to this specialized investment area. The terms below are not listed in any particular order, but rather try to tell a story about why REPC is important and how to start thinking about it as an investment.

Margin of safety. I list this first because the top advantage of private credit vs. private equity investments is lower risk. The margin of safety refers to the difference between the loan amount and the value of the underlying asset. The larger the margin of safety, the lower the chance of ever losing principal. Credit goes to Warren Buffett for popularizing this phrase, and it applies equally well to our business as it does to his.

Capital preservation. Capital preservation refers to the goal of not losing any principal when making an investment. Some funds have capital preservation and income as their most important goals, in that order. Other funds — typically those targeting higher returns — list capital preservation as a goal, but in practice they are doing whatever is necessary to target higher returns, and capital preservation may be partially sacrificed in the process. Buffett has a great quote on this topic as well: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”

Loan-to-value (LTV) ratio. This is related to the margin of safety. If a property is worth $1 million and the loan amount is $700,000, then the margin of safety (also known as the equity) is $300,000. This would correspond to an LTV of 70%.

Collateral. In real estate private credit, loans are secured by a lien on an underlying property. This property is known as the collateral. Real estate collateral is nice because unlike equipment, cars or fine art, it can’t roll away or be shipped out of the country.

Lien. A lien is a claim that some party — such as the creditor or lender — has an interest in a property. If a lien is not cleared (or “reconveyed”) before a property is sold, then the buyer acquires the property “subject to” the lien. In other words, they still owe money to the lienholder, and they do not own the property free and clear. Liens, together with the well-established institution of “title” and “recording” in every county in the U.S., explain why real estate lending is so popular as an investment. Fun fact: You can see all the owners and lenders on any property over time by looking at what’s recorded on that property at the county in which it is located. This is known as the chain of title.

Senior loan. Also known as a first trust deed, a senior loan is one that gets paid off first if the property is sold. A senior loan is the safest type of loan on a given property. Personally, I have had very positive results investing in senior loans (including more than 1,800 loans made during the past 15 years).

Junior loan (also known as a subordinated loan). A junior loan is one that is recorded behind the senior loan. In other words, it is not first in line to be paid off, and is therefore riskier. My own experience with junior loans is mixed. The main problem is that the junior lender must be prepared to service the senior loan in case of a default in order to avoid being wiped out. We once did this and would have been better off just walking away from our investment.

Maturity. This refers to the amount of time before the borrower is required to pay back a loan. The shorter the maturity, the less risk for the lender (the private credit investor), because the value of the underlying property is less likely to fall dramatically if the amount of time elapsed is shorter.

Volatility. This term refers to the propensity of a given property’s value to change by a large amount over a relatively short period of time. If a property’s value is likely to be volatile, the lender or private credit investor is taking on relatively more risk. An example of a property whose value is likely to be volatile would be development land. A relatively small change in development costs or interest rates can lead to a large change in the value of a development land property.

Interest rate. This is the rate of return that a borrower pays their lender. A higher interest rate is more appealing to the lender or private credit investor. However, as my former employer and mentor Sam Freshman used to say, “If the borrower isn’t worried about the interest rate, it’s because they aren’t planning to pay the lender back!”

Origination fee. In private credit, the borrower typically pays an origination fee to the lender at the time the loan is funded. A 1% origination fee means 1% of the loan amount, so on a $1 million loan the fee would be $10,000. Frequently, this fee is paid out of the proceeds from the loan.

Extension fee. If the loan reaches maturity, frequently the borrower has the right to extend the loan so long as the conditions are met. If the borrower extends the loan, they often pay an extension fee.

Personal guarantee. For smaller loan amounts, the key principal of the borrower often signs a guarantee promising that the loan will be repaid. This is less common on large loans on institutional-sized properties.

Structural leverage. This nuanced concept refers to the fact that many real estate private credit funds not only lend money to borrowers, but the REPC funds themselves also borrow money, typically from banks. Using structural leverage can enhance the returns from investing in REPC, but it also increases the risk that returns will be volatile. For more information about how REPC funds use borrowed money, please refer to this FAQ.

Open-ended fund. When setting up their REPC funds, investment managers need to decide whether to structure their fund as open-ended or closed-ended. An open-ended fund, also known as an evergreen fund, means that the fund may go on for many years and has no set wind-down date. Open-ended funds allow investors to add capital or redeem capital invested over time.

Redemption rights. For an open-ended fund, redemption rights refer to the process by which an investor can request to have their invested capital returned to them. Redemption rights include when an investor can request a redemption, and the timeline and terms under which the fund is required to redeem their capital.

For a more detailed description of private debt funds, how they operate and risk factors to consider, and a more extensive glossary of terms, please check out this guide.

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