Read the loan before the brochure

Many private real estate presentations open with the building: the drone shot at golden hour, the renovated kitchen, the pool on a quiet afternoon. It is a reasonable place to start. The building is real, you can walk it, and a good one is pleasant to look at.

It is often not where the trouble starts. When a private real estate investment struggles, the building may still be standing, leased and collecting rent while the arrangement underneath it, the loan, is under strain. So before reading what a sponsor hopes will happen to a property, it is worth reading what the loan documents provide for if things go differently.

The part a photograph leaves out

Apartment purchases are commonly financed with borrowed money for a large share of the price. Leverage is what turns a modest improvement in a building's income into a meaningful change in the value of the equity, and it works in both directions. A property bought with a large loan has less room for error, because debt service generally has priority over distributions to the owners, and the equity typically bears the first loss in value.

That makes the loan agreement the most important document in the deal after the operating agreement. It sets the cost of the money, how that cost can change, when the money must be returned, and what the lender can do if the property misses its targets. None of that shows up in a photograph.

Fixed, floating, and the cap in between

A fixed-rate loan fixes the interest rate for its term. A floating-rate loan resets with a benchmark rate, so the interest cost moves when rates move. Floating-rate debt is often cheaper at the start and easier to repay early, which is why business plans built around renovation and a sale within a few years tend to use it.

Some floating-rate loans require an interest-rate cap. The cap provider pays when the specified benchmark exceeds its strike. A cap may expire before the loan does, making replacement costly when rates are high, and it does not ensure the property can cover its debt payments.

Maturity: the date that decides the ending

Every loan has a maturity date, the day the balance is due. Many business plans assume the property will be sold or refinanced comfortably before then. That assumption quietly depends on three things no single party controls: interest rates, how much lenders are willing to lend, and what buyers will pay on that particular day.

When a loan matures in a weak market, the choices narrow quickly. The owners can refinance on worse terms, put in more money, sell at a lower price than planned, or negotiate an extension with the lender, who now holds most of the leverage. The building has not changed. The calendar has.

Covenants: the lender's seat at the table

Loan agreements also contain covenants, conditions the property must keep meeting. A common measure is the debt service coverage ratio: net operating income divided by debt service. When the loan documents provide for it, falling below an agreed level can let the lender trap cash, require reserves or take further steps. These provisions matter little in a good year and a great deal in a difficult one.

A recent lesson

Between early 2022 and mid-2023, the Federal Reserve raised its benchmark rate from near zero to above five percent. Properties financed with short-term floating-rate debt near the bottom of that cycle faced higher payments, costly replacement caps and refinancing at lower valuations, sometimes all at once. For some of those properties, the difficulty had less to do with operations than with arithmetic set years earlier in the loan documents.

The lesson is not that floating-rate debt is always a mistake. It is that the financing deserves as much scrutiny as the property, and that a plan which only works if rates cooperate is, underneath everything else, a bet on rates.

Questions worth asking about any loan

• Is the rate fixed or floating, and how much of the purchase price is borrowed?
• If floating, is there a rate cap? At what level, and when does it expire?
• When does the loan mature, and what conditions attach to any extension options?
• What does the property's cash flow look like if rates stay where they are until maturity?
• Which covenants apply, and what happens if the property falls short of them?
• Is any part of the loan personally guaranteed, and by whom?

None of these questions is exotic, and a well-prepared sponsor will have answers ready. If the answers take a long time to arrive, that is information too.

Risks and limits

This essay describes common features of real estate financing in general. It is not an analysis of any particular property or offering and it is not a forecast of interest rates. Loan terms vary widely, and the documents of a specific transaction control. Leverage increases the risk of loss, including the loss of an investor's entire investment.