First Mortgage Debt as a Cash Flow Investment in a Yield Compromised Market

Authored by Trevor Schuesler, Investment Director and Raymond Hu, Head of Real Estate Credit

September 27, 2022


In the not-so-distant past, equities were considered ideal additions to well-performing portfolios, generating high yields and appreciation. That does not seem the case these days. Economic volatility continues pummeling public stocks and private shares, meaning increasing equity investment risk and lower returns.

Lower-risk investments exist. Including first mortgage debt as an investment. Because of how these assets are structured, first mortgage debt can provide equity-like returns and lower risk, helping to improve portfolio diversification.

Introduction to First Mortgage Debt

 A first mortgage is the primary lending source for real estate acquisition, refinancing or capitalization, using property as collateral. This type of debt finances residential properties (single-family homes) or commercial real estate (multifamily, industrial, office, and retail). First mortgage debt investments give investors ownership of these notes secured by property, as well as cash flow from borrower payments.

Commercial first mortgage debt as an investment tool can offer better yield, boasting higher interest rates, larger loan repayments and shorter term maturities. Another advantage is creditor priority above other liens in the event of default. This means that if a borrower stops paying the loan on the property (for whatever reason), the note investor can foreclose and sell the property to pay down the mortgage debt.

Higher Cash Flow Returns Bond-Like Risk

How does first mortgage debt yield compare to that of stocks and bonds?

According to the Official Data Foundation, publicly traded stocks delivered annualized returns of about 10%, two-fifths of which came from dividends1. As of June 2022, U.S. stocks and bond yields were approximately 1.5% and 4.5%, respectively2.

By comparison, first mortgage commercial real estate debt can generate mid-teens returns, first mortgage debt can provide higher cash flow returns at lower risk.

Base Rates

Base rates vary widely, and often represent the lowest interest rate on money that banks, or other capital sources lend to other entities. They’re also important when identifying first mortgage debt for investment purposes.

For instance, Kairos originates 24 to 36 month acquisition, recapitalization, and refinance funding on completed commercial real estate projects. Cash flow from the loan are calculated at about 6% to 8% above Secured Overnight Financing Rates, or SOFR, as well as forward curve, exit fee, leverage, and tax benefits, which will be discussed more deeply below.

Forward Curve

First mortgage debt is typically positioned as a floating rate over a reference rate like SOFR, the interest rate connected to the cost of overnight bank borrowing and based on U.S. Treasury repurchase agreements.

In the current high inflation and increasing interest rate environment, these reference rates are rising quickly and expected to be higher over the next few years. The current forward curve shows SOFR above 3.5% in 2023, which could meaningfully increase interest rates on floating-rate first mortgage debt.

By how much? We’re estimating a roughly 1.5% average yield improvement from rising rates in the coming years on floating rate first mortgage debt.

Exit Fee

Borrowers pay exit fees when paying off commercial loans. These fees can range between 0.5%-2.0% of the overall loan amount, adding about 0.5% to a first mortgage debt’s annualized return.

Leverage

Institutions use both debt and cash when lending to borrowers. For the lender, this boosts yield without incurring last-dollar risk. For instance, a lender can advance a $20 million using $10 million from their balance sheet and $10 million in debt and increase the yield of a first mortgage investment. This can be highly accretive when there is a large spread between the loan interest rate and the interest rate of the mortgage debt. Depending on that spread and the amount of leverage used, leverage has the potential to add an additional 2%-7% in yield to our first mortgage investments.

Tax Adjustment

First mortgage debt REITs offer a compelling tax advantage, as they pay out through qualified REIT dividends. Taxpayers can generally deduct 20% from these payouts, adding another 1%

to the investment’s tax-adjusted yield.

Summing it Up

First mortgage debt investments can help diversify portfolios, offering high cash flow returns with lower bond-like risk in today’s volatile economic times. The next article in this series focuses on risk and principle protection. To learn more about first mortgage debt investments, contact Kairos at investorreporting@kimc.com.

 

*This article is meant for educational and informational purposes only and should not be considered as a recommendation of any type, investment advice, an offer of services, or an offer to sell, or solicitation of an offer to buy a particular security or investment strategy. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. The article may contain forward- looking statements which are not guarantees of future performance or future events and are subject to risks, uncertainties, and assumptions. Any forward-looking statements speak only as of the date they are made, and Kairos assumes no duty to update forward-looking statements. Kairos is not providing tax advice; each taxpayer’s tax situation may vary and interested parties should consult with their own tax professionals. There are no guarantees that any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. The views and opinions expressed in this article are solely my own.

 

1 “ S&P 500 Data.” Official Data Foundation, 10 June 2022, https://www.officialdata. org/us/stocks/s-p-500/1926?amount=100&endYear=2022.

2 “S&P 500 Dividend Yield.” Multpl, 10 June 2022, https://www.multpl.com/s- p-500-dividend-yield. “ICE BofA BBB US Corporate Index Effective Yield [BAMLC0A4CBBBEY].” FRED, Federal Reserve Bank of St. Louis, 10 June 2022, https://fred.stlouisfed.org/series/BAMLC0A4CBBBEY. “iShares Core U.S. Aggregate Bond ETF.” iShares, 10 June 2022, https://www.ishares.com/us/ products/239458/ishares-core-total-us-bond-market-etf.

 3 These returns do not include fees PLUS transaction cost.

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