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 are 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:
What are the standards used to assess credit and underwrite the debt?
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 defense 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-tovalue (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.
First Lien position - To ensure that investors have a priority claim on the underlying collateral, we only provide senior debt financing secured by a first-lien on the property. In fact, our loan documentation prohibits borrowers from burdening the borrowing entity or the property with additional debt during the term of our loan. Furthermore, our loans may require tax (and insurance) impounds to avoid a tax lien priming our secured lien.
Short-term focus - It is important to note that the bridge loans we make to borrowers are between one and three years. Since it is much easier to project the performance of commercial real estate properties a couple of years into the future than a decade or more, we believe short-term loans are by their nature less risky than long-term loans.
Once a potential borrower passes these initial qualification checks -
income-producing commercial real estate,
a healthy down payment or owner’s equity,
no second liens,
a personal guarantee (where applicable), and
short-term loan -
The borrower and the property undergo rigorous, institutional-quality underwriting by our highly experienced in-house team of loan analysts, underwriters, credit officers, and risk managers all of whom are backed by top-tier independent appraisers, environmental consultants, title examiners and other third-party experts.
A close-up look at how we underwrite commercial real estate loans
Each member of our underwriting team has on average 20+ years of experience in commercial real estate lending and has been through two, or even three, downcycles. This means they have deep insight into what attributes of the loan will help support its durability during adverse circumstances, such as a borrower default or restructuring.
As part of our due diligence process, our underwriting team analyzes each property’s condition and operations. They examine revenues and expenses, rent rolls, terms and conditions of leases, the quality of tenants, conditions of the market in which the property is located, zoning and environmental issues, and potential seismic, flooding and other hazards. Credentialed, top tier MAI appraisers (Member Appraisal Institute) provide an objective “as is” appraisal and valuation. An “as is” appraisal is the current value of the building today. It is recognized in the industry as being more conservative as it is looking at the current value only and does not take into consideration the projected value of the property once improvements are made. Appraisals based on projections of cash flows one or more years out are called “as stabilized” appraisals.
Next, we look closely at the borrower’s professional and personal qualifications, capabilities and track record. We evaluate the borrower’s background, including business experience, personal credit history, net worth, litigation history and other potential issues. Our goal is to determine whether the borrower can deliver on our expectations for the property’s performance, and in a position to comply with the terms of the loan agreement – especially if problems arise. The structure and terms of our loan documents provide us with additional safeguards. We structure the financing at a level believed sufficient to protect the mortgage assets/investor interests, that the property is legally pledged, and that the loan is publicly recorded. As part of the loan underwriting process, typically major or important tenants are asked to sign an estoppel, which is legal declaration certifying that certain facts regarding the lease are true and accurate. For example, in the case of a foreclosure, an estoppel avoids any undisclosed “surprise” lease terms where we, as the foreclosure owner, step in as the new landlord. Further in the case of foreclosure, the documents sometimes require leases to be “subordinated” to our debt such that we, as the foreclosure owner, would have significant control over the tenant.
After closing, Money360’s asset management team focuses on monitoring and managing each loan’s performance. While many lenders outsource the asset management and servicing to low-cost third-party providers, we contract with Wells Fargo Commercial servicing, a rated and bonded leading commercial real estate loan servicer to handle the administrative aspects of payment collection, cash management and loan surveillance data collection. These efforts increase the likelihood of being forewarned about a pending issue before it becomes a problem.
What happens when a borrower stops making payments?
Even after our vetting process and after completing an extensive underwriting process, problems can still arise, whether they are related to the borrower, the property, or the current real estate cycle. Therefore, investors need to understand “what happens when the borrower stops paying?”
A borrower may run into difficulties paying on a loan for reasons ranging from a temporary business set back, tenant’s unexpected departure or the timing of cash flows. Our Asset Management department is staffed and skilled to be able to work with the borrower to either get them back in compliance or take action to have the debt paid back.
Workout situations are multifaceted and no two are the same. There is never just one answer, which means finding the best solution is part science and part art. A key part of the Asset Management teams’ job is to work with the borrower, apply pressure and avail ourselves of all available legal remedies to obtain a favorable resolution for investors. The merits and protections of an investment backed by secured mortgage assets include:
Legal documents that protect lender/investors rights
Borrower guarantees --personal guarantee or limited recourse guarantee
Recorded legal claim to the physical asset collateral
Time is on the side of the lender / investors (no “forced selling”)
Seasoned and highly skilled portfolio management, asset management and servicing departments
Our Asset Managing team is extremely effective when it comes to loan workouts as members (at other times in their careers) have acquired and worked-out over $800 million of non-performing loans.
Our first priority is to engage with the borrower to bring a late paying or a slow paying loan current. Our asset managers have multiple strategies they can use to resolve “slow pay” situations. Our team likes to get involved early on and work directly with the borrower to
understand the situation, which typically involves frequent – even daily – communication with the borrower to work toward a resolution.
Legally, as servicer we have the right to issue a Notice of Default as soon as a payment is overdue. Typically, payments are due on the first of the month and often there is a 10-day grace period, as well as a cure period. Therefore, it is possible to file a notice of default very quickly. In some cases, Asset Management will immediately move to foreclose, while at other times it may be determined that the best interests of investors will be served by giving the borrower time to cure, as both parties are better served with a performing loan. Regardless of whether Asset Management chooses to move to foreclosure or provides time for borrower to cure the default, the asset manager can apply to the courts to appoint a receiver who steps in as manager of the property, collect the rental income, pay the expenses and make sure the mortgage payments are made.
If we are not confident that the borrower will be able to bring the loan current, we may offer the borrower the option to give us a “deed in lieu of foreclosure”, or “DIL.” For us, a DIL is quicker and less expensive than a formal foreclosure. It also allows the borrower to avoid a public foreclosure sale and terminates the borrower’s liability on the loan, including the personal guarantee on the debt.
How does a foreclosure work?
We will pursue foreclosure if a borrower is unwilling to provide a Deed-In-Lieu or if we otherwise deem it is in the lender’s (i.e., investors’) best interests. The length of time a foreclosure process takes will vary from state to state, and the time frame can range from months to years, as the process can be extended if the borrower files for bankruptcy or seeks a court-ordered “stay.” However, through the “assignment of leases and rents” provision we may be able to collect rents from tenants of the property during the foreclosure process, keeping all or partial income payments flowing to investors. This aspect is vastly different from residential lending where owners retain the benefit of living in the house or renting it out for months or years while the foreclosure process winds its way through the courts.
The end-result overview of foreclosure
In theory, a cash bidder could offer more than our credit bid, but this is unlikely for several reasons. In the few weeks between advertisement of the sale and the auction itself, a cash bidder would have to evaluate the property – a complex process for a commercial building. Also, a winning bidder must produce the cash at the time of the auction, which in the case of our loans would entail a multi-million-dollar payment. For these reasons, few potential bidders are in a position to make cash bids for a commercial real estate loan.
As the owner of the loan, we would have a significant information advantage over outside cash bidders, making it possible that our credit bid would be the winning bid in a foreclosure sale. We would then seek to sell the property for an amount that could potentially exceed the original principal amount of the loan, thereby boosting the return to our investors. Once a property has been acquired in foreclosure, it is possible that it can be sold in six to nine months. (A REO (real estate owned) property is a property now owned by the lender/investors after foreclosure has been completed.) In the meantime, as the new owner of the property we would continue to collect rents or other cash flow it generates, or perhaps improve the asset or work to lease out more of the building.
If mortgage assets have a loan to value 65% to 70% of a property’s value at origination, although it is possible, we believe it is unlikely that the asset would be worth less in a foreclosure auction than our credit bid. However, should this occur, we still have three possible sources of value to recover the amount of our loan.
The first, of course, is the property itself and the income it generates.
The second is a deficiency judgment against the borrower for the unpaid balance of the credit bid.
Finally, we could hold the property, and aim to sell at a future date to realize an amount equal to or greater than the credit bid.
These multiple strategies for recovery, even in a foreclosure scenario, help to mitigate or avoid loss of investors’ capital. Having property as collateral and the legal rights to secure it to satisfy the debt, combined with our rigorous underwriting process, is what makes investing in commercial real estate loans such an attractive investment.
The value of investing in a commercial real estate (CRE) fund
It’s important to remember that a fund structure also serves to mitigate investor risk, as a fund is diversified with potentially hundreds of loans throughout the United States and in multiple asset classes (office, industrial, multi-family, etc. buildings). So, while some number of the mortgage assets in a fund may be slow paying or in workout, a fund structure allows for regular and consistent income payments to investors while the Asset Management team is working to bring late paying loans current, complete the foreclosure process or recoup all or as much capital as possible on an REO property.
Investors are well aware of headline stories about banks frequently liquidating millions of dollars of loans at a significant discount. What is less well known is that banks are not incented or equipped to go through a workout or the foreclosure process; therefore, it is widely assumed that a non-performing or defaulted note must always be written off at a substantial loss or sold a deep discount. The main reason banks quickly sell off non-performing loans is because of government regulation on bank capital and “set-aside” ratios. For a bank to hold and work out a non-performing loan is so cost inefficient that it is financially beneficial for the bank to liquidate the loan at a discounted sale price. However, Funds that own non-performing loans are under no time pressure and can “wait it out.” This is a notable advantage as negotiations and legal proceeding progress. Investors holding mortgage assets have the upper hand given the loan structure, legal documentation and recording of the lien which is why ultimately (albeit several months to years) the lender / investors often prevail and not only recoup the principle balance owed and interest due, but also late fees and default interest. (Loan documents typically call for an increase the interest rate once the loan is in default). It takes time, but lenders/investors can actually make more on non-performing loans.
As described, a fund structure affords us as servicer considerable options to protect investors interests. Unlike banks which are typically not set up to handle workouts from two standpoints. First, federal regulatory capital requirements force banks to set aside capital against nonperforming loans, so a non-performing loan will shrink the asset side of a bank’s balance sheet and thus reduce its capital. Therefore, the bank is incented to sell off loans versus holding them and working them out. Second, banks do not have the departments or staff to apply the ‘part science, part art’ discipline necessary to see a loan through to a mutually agreeable resolution. Therefore, banks write down, liquidate and take a loss on nonperforming loans.
An investment team managing a private, diversified portfolio of loans not only has the time, but the ability to hold the loan (or the property itself in the case of an REO) as long as necessary to work toward the best resolution for investors. Since loans are made with the borrower putting 25% or more down on a property’s value, lenders (and investors) through a foreclosure might end-up owning the asset free and clear at 75 cents or less on the dollar. And then can decide the best time and way to liquidate the asset.
In the case of an REO property a fund structure offers several options to exit:
sell the property immediately
hold the asset until the market improves and sell
re-tenant, renovate, reposition and sell
Most investors, if given the choice, would prefer to realize the maximum potential value on their investment, rather that writing off a loan at cents on the dollar. A fund backed by a portfolio of commercial real estate loans offers that possibility—banks typically are not incented, set-up or have the time to avail themselves of all the controls afforded to them in the legal documentation.
In addition, with respect to foreclosure or other workout scenarios investors within a fund structure continue to receive quarterly income payments on the other mortgage assets in the fund that are performing while professional asset managers handle the workout or foreclosure process. As mentioned earlier, it is even possible for investors to benefit beyond the original loan terms given the ability to collect late fees and default interest on top of original principal and interest owed.
Senior debt - the most secure part of the capital stack, average loan value to 65%
Collateral backed - first lien, secured against income-producing commercial real estate
Legal rights - executed loan documents and recorded deed to secure rights to collateral
Equity buffer - the borrower is in the first loss position, given the down payment or equity value is on average at 35% (i.e., a 35% buffer before investor capital is risk). Borrower has “skin-in-the-game”.
Institutional credit analysis and underwriting - by commercial real estate finance veterans using institutional quality credit and underwriting procedures
Borrower guarantees - personal guarantee or limited recourse guarantee. Borrower has entire balance sheet at risk in case of default.
Loan documentation – ability to monitor and take action if borrower is out of compliance with loan terms
Fund structure – highly diversified (property types, geographies and borrowers)
Asset management and loan servicing teams – professional experience in utilizing the tools and strategies, including (1) enforcing loan covenants, (2) negotiating compliance with loan documents, (3) using receivers to “take over” management of the property, collect rents and pay expenses, including the mortgage payments, and (4) foreclosing and “taking back” the property.
Time – A Fund can be a patient workout specialist (vs a forced seller) working in the best interest of the investor to recover amounts owed
Professional portfolio management – ability to decide if/when to improve, hold or sell
The powerful combination of all these factors are what makes investing in mortgage assets secured by commercial real estate - an increasingly popular investment choice, in all stages of the economic and real estate cycles, and it is a particularly attractive vehicle for those investors “looking for a port before the storm.” These are the reasons why both institutional investors and other accredited investors have been investing in the private credit sector as source of risk adjusted returns, diversification, consistent income stream and high absolute return.
For questions or more information (including a mortgage asset, portfolio stress test model),
contact Laura Catalino, Senior Vice President of Investor Relations, at (949) 528-3610 or
To view the wide range of CRE loan types and rates click here
Special Thanks to Our Contributor
M360 Advisors invests in niche segments of private credit and manages a vertically
integrated credit strategy that targets short duration commercial mortgage assets
secured in first lien position by income-producing properties. The firm’s objective is to
preserve invested capital and achieve attractive and sustainable risk-adjusted returns
relative to traditional fixed income investments, while also providing reasonable liquidity
to investors. M360 Advisors oversees the entire value chain internally – from sourcing
loans all the way through to portfolio management.
By focusing exclusively on secured investments that are senior in the capital structure, we are able to deliver to our clients a rare combination of stable, uncorrelated returns with significant collateral protection.
Senior Vice President of Investor Relations, M360 Advisors