What Investors Need to Know about Senior Debt Mortgage Assets, Secured by Commercial Real Estate

An In-Depth Look at Downside Risk

Every investment comes with a measure of risk, and understanding the sources of that risk plays a key role in making a prudent investment decision. When it comes to private credit there is a wide range of factors that will determine the potential risk-adjusted return, and those factors may vary widely.

Investors looking at investing in mortgage assets secured by commercial real estate (CRE) typically ask two key questions regarding credit risk, as part of their due diligence process:

1. What are the standards used to assess credit and underwrite the debt?
2. What happens to the investment should a borrower not meet payment obligations?

The appeal of investing in commercial real estate mortgage assets is equity like returns without the volatility and / or a high and steady current income stream. In addition, investors seek preservation of capital and as an investment manager that is our highest priority too. In addition to the detailed analysis undertaken to reach each loan decision, structuring a pool of mortgage assets is another layer of protection. The expectation is that fund investors will receive current income on the vast majority of the portfolio’s performing mortgage assets while affording the asset management / servicing team time to work out and recover income owed to investors.

Although many institutional investors may be familiar with investing in commercial real estate debt, the market has become much more bifurcated as traditional lenders have stepped back and private lenders have gained market share. With the increased interest from accredited investors, now is the time to review what to look for in a potential investment and how to answer these two key questions.

Benefits of investing in short-term, bridge loan mortgage assets

Private debt has become an increasingly popular asset class in today’s market environment. With interest rates near a 30-year low, many investors are looking for attractive risk-adjusted returns to supplement, or even replace, the fixed income portions of their portfolio.

• Buying a Treasury note backed by the United States government involves virtually no risk, the returns are not attractive.
• Investing in high-yield investments such as high yield bonds or unsecured consumer loans may offer attractive returns, but lack adequate downside protection.

In contrast, investing in short-term, bridge loan mortgage assets offers:

• Potential for significantly higher yields compared to traditional fixed income investments
• Current income, quarterly distributions
• Short investment horizon (bridge loan mortgage assets typically mature in 1 to 3 years)
• Collateral protection in the form of senior, 1st-liens, secured by commercial real estate

In many cases, the loans are also personally guaranteed by the borrower, providing another potential source of repayment, minimizing downside risk.

Risk mitigation through strong underwriting

It is widely accepted that senior debt is the most secure position in the capital stack and is used as a means to protect investor capital. At M360 Advisors, protecting investor principal is of paramount importance, which dovetails with our decision to focus on senior secured debt. In addition, we added collateral backing of income-producing commercial real estate. This offers investors the benefit of “belt and suspenders” risk mitigation.

That’s why throughout the underwriting process Money360 focuses on strong credit assessment, evaluation and building in layers of defence to mitigate risks.

• We attempt to screen out all but the best credit opportunities, while also identifying potential risks.
• We then mitigate those risks through institutionally based underwriting process, utilizing our decades of experience in the commercial real estate sector, the structure of our loan agreements, and rigorous monitoring of the loans we extend.
• In fact, our review process is so rigorous that we approve and closed less than 10% of the billions of dollars in loan requests received.
• Currently we source about $1.2 billion of lending opportunities per month.
• Then we cull through these opportunities to identify $300 - $500 million that are assessed in greater detail.
• In the end we close about 4% to 8% of the lending opportunities that we see, between $50 - $100 million per month.

So, what does this underwriting process look like?

• Screening - Our initial screen is the sector in which we operate. We provide financing only on income-producing commercial real estate, including office buildings, industrial buildings, multi-family housing and alike. Unlike a loan secured by a home mortgage, where mortgage payments depend solely on the homeowner’s income, the cash flow from tenant leases provide the primary source of repayment for a commercial real estate loan. Our loan underwriting focuses on the stability and the durability of the cash flow coming from lease income. The credit staff investigate each stream of lease income to ensure that the rents are consistently documented and received as well as their conformance to market rental rates, which helps determine the likelihood of the tenant continuing to pay the lease rent. Properties with no or questionable streams of lease income are avoided, such as land development and ground-up construction projects.
• Skin in the game - We require our borrowers to have “skin in the game” in the form of a cash down payment or equity value of the property that, on average, is equal to 30% to 35% of the current appraised value. Our loans, therefore, have a loan-to value (LTV) at generally 65% to 70% of the current “as is” value of the property. This level of investment by the borrower provides a significant “cushion” between the loan and the value of the property, especially if the property eventually has to be liquidated. We choose to use conservative LTV ratios to mitigate risk for investors and to give borrowers a substantial incentive to honor their repayment obligations. At times, an additional measure of “skin in the game” is added with the borrower personally guaranteeing the loan. Even though we look to the income generated by the property as the primary source of repayment, we know that a personal guarantee strengthens a borrower’s motivation to pay, and also offers investors an additional potential source of repayment.