by | Oct 26, 2015 | Real Estate

Last Updated: October 26, 2015

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Real estate investments in Debt

Real Estate Debt is broadly divided into two types; Residential Mortgages and Commercial Mortgages. The main differences are in the characteristics of the borrower, the Residential Mortgage borrower will usually be an individual and will produce no other income when the borrower is also the occupier. The focus is then mainly on the credit worthiness of the borrower or group of borrowers. These mortgages are usually considered less risky as they are often mostly insured. Commercial Mortgage borrowers tend to be corporations or other legal entities. The focus on commercial loan borrowers is on the rental revenue that can be generated by the property and used to make the mortgage payments. Another characteristic of residential loans is they that they tend to be more homogeneous than commercial loans.

Residential Mortgages

Mortgages come in two types, fixed rate or floating rate loans. The fixed rate loans are subject to interest rate risk and inflation risk. Interest rate risk arises when rates move in either direction. Lower interest  rates are a risk as refinancing the loan at new lower rates becomes more convenient the lower interest rates fall. This creates diminishing returns as the overall life of the mortgage becomes shorter and interest received is less than initially contemplated at the beginning of the investment. The additional payments received will then have to be reinvested at prevailing lower interest rates creating further loss. Early repayment is often possible but due to the option like nature of this feature it usually comes at a cost. Usually there are penalties included in the mortgage in the case of early repayment which may off set slightly the loss in interest payments. Higher interest rates will mean that the fixed rate loan will diminish in value. Investors will want to pay less for an existing loan to discount the higher yield needed to reflect a higher interest rate scenario.

Common amongst fixed rate residential mortgages are interest only loans. These loans consist of an initial period where only interest is paid after which the payments then include principal capital to amortize the loan fully to maturity. The two most common structures are 30 year loans with the initial 10 and 15 years as interest only payments followed by 20 and 15 years of fully amortizing payments. This gives the borrower the advantage of lower initial monthly payments at the cost of higher payments later. For the investor this has the advantage of higher total interest payments.

Floating rate mortgages are considered to behave like short term money market instruments. These loans see the interest rate reset every X months. So every X months the lender is investing at a revised interest rate for X months, creating effectively a series of cash investments. This allows the investor to avoid the risks involved with fixed rate mortgages as these loans will see their price less subject to changes in the general level of interest rates and they are less likely to see early repayments as rates fall.

Commercial Mortgages

All commercial loans are backed by commercial property such as Hotels, Offices, Retail Outlets and Industrial Properties. The borrowers are corporates or other entities so these two factors lay the bases for an extremely unstandardised loan market. Corporates are more sophisticated than the average home owner and mortgages tend to have varying terms. Usually they will include a balloon payment, which requires a large payment at the end of the loan. This is done so that monthly payments are tailored to fit the borrowers needs. It is important to distinguish between loans for completed projects or for development, which may be riskier as the outcome may be less certain. Loans for development are drawn down on an as needed basis for each construction phase and do not usually go past 3 years in duration. Loans for developed projects have longer maturities usually between 5 and 10 years, in this case the full amount of the loan is issued at inception.

Commercial mortgages are also more likely to have restrictive covenants, which may not necessarily only penalize the borrower. The investor in return for the covenants will be willing to accept a lower interest rate as the investment can be considered less risky. The most common covenants are Recourse and Cross-Collateral Provision, although it is also usual for the covenants to cover seniority of the loan in the case of financial distress. Recourse allows for how the loan is secured, as to the possibilities of the lender to take possession of the property and whether the lender has the right to pursue recovery from the borrower’s other assets. Cross-collateral provision is used to mitigate the risk to which lenders are exposed by using more than one property to secure a loan. For example a corporation has taken out a loan on one property and then takes out a loan on a second property. The lender may use both properties as collateral for both loans, so in the case the borrower pays one loan off fully the lender may still not allow the sale of the corresponding property as it also serves as collateral for the existing loan.


There are various ways to access Real Estate Debt exposure but the main three are Residential Mortgage Obligations (RMBS) Commercial Mortgage Obligations (CMBS) and Real Estate Investment Trusts or commonly known as REITs. With the first two the issuer of the security pools together various loans and packages them together in a bond that will pay a coupon and have a maturity close to the average duration of the pooled loans. The pooled loans serve as collateral for the bond, this reduces the total risk of investing in Real Estate Mortgages as the risk is spread across many borrowers. This type of security however does not offer a very liquid secondary market and may be very sensitive to changes in interest rates as well as default rates.
REITs are funds that issued shares to the public, the capital raised is then used to make investments in Real Estate Mortgages, as the shares are exchangeable holding this security allows for more liquidity to exit the investment at any time if needed.

Gino D'Alessio

Gino D'Alessio is a Broker/Dealer with over twenty years experience in various OTC markets such as Bonds, FX and Derivatives. Currently a Financial Markets and Investments Writer & Analyst