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PAGE 7 | Alternative Income for an Unpredictable World: Understanding Private Debt Funds

How Arixa Capital and Lone Oak Fund Focus on Different Corners of the Real Estate Lending Market

Private debt funds have the ability to focus on specific segments of the real estate market. The decision to specialize enables management teams to develop a deep understanding of specific market dynamics, as well as provide for long-term, trusting relationships with experienced borrowers in that kind of real estate. Examples of such niches include single-family home renovations and multi-unit property construction in the residential segment. In the commercial segment, lenders can focus on office buildings, mixed-use, warehouse/logistics, retail, industrial and others. Below are two examples of private debt funds with slightly different areas of focus.

Arixa Capital manages levered and unlevered funds that are primarily focused on single-family and multifamily real estate projects. Over the past decade, the firm has focused on supply-constrained urban West Coast markets that have historically had less price volatility. Since inception, Arixa has funded over 1,700 loans representing in excess of $1.7 billion invested on behalf of its fund investors, and has generated positive investor returns for every month since Arixa launched its first fund in 2010.

According to Greg Hebner, Managing Director at Arixa, the firm’s lending platform provides a one-stop shop for clients that handles all aspects of the lending process, from origination through servicing. “This enables Arixa to deliver a consistent and high-quality service experience for its valued clients,” says Hebner. “This level of service is a primary component of the firm’s marketing strategy, and the great majority of loans are made to existing borrowers, or referrals from those borrowers.”

The firm measures its customer satisfaction through a robust Net Promoter Score (NPS) program for each loan originated to ensure it is delivering on its customer service promise. Historically, Arixa’s NPS ratings have been in the mid-90s, which places the firm in the highest decile of U.S. companies.

Arixa’s loans are short-maturity (6-18 mos.) and range in size from $500,000 to $10 million. In the majority of cases, these loans involve the renovation or repositioning of the property by the firm’s borrowers. Arixa’s goal is to make loans in which the borrowers are creating meaningful value during the time the loan is outstanding, with a goal of bringing the final loan-to-value ratio into the 60-65% range. 

Lone Oak Fund, LLC has lent on a wider variety of property types than Arixa Capital. Lone Oak has retained a steady focus on lending for apartment buildings and industrial buildings. As far as CEO and Co-Founder Jerry Ducot is concerned, these types of commercial buildings tend to have the lowest risk in terms of occupancy rates. In contrast, lending on office building and retail-focused buildings holds greater risk, and therefore, less appeal. 

Lone Oak’s approach has led to a strong track record of limited foreclosures and consistent 6% or higher returns. Unlike some private debt funds, Lone Oak does not use structural leverage. “We are less interested in yield and more interested in security,” says Ducot. Lone Oak’s loans are typically up to $25 million in size. 

How has a firm that has completed over 6,000 loans seen very few loan defaults? Lone Oak keeps the loan-to-value ratios below 60% on almost all loans it issues. Even on the rare occasions that a loan has defaulted, “each one of those assets were re-sold at break-even or a profit,” notes Ducot. 

The firm currently has 450 loans in place, and that level of diversification helps shield against the impact of a few loans having workout challenges. Unlike some lenders or traditional banks, Lone Oak doesn’t provide forbearance during challenged economic times. “Our borrowers have access to other assets and funding sources and we insist that they pursue those options instead of forbearance.” 

There are two other notable differences between Lone Oak and Arixa Capital. First, Lone Oak considers its main clients to be mortgage brokers who maintain relationships with property owners. Arixa makes most of its loans directly to investors and developers, without a mortgage broker involved. The two firms define their target customers in a totally different way.

A second difference is that Arixa Capital’s loans frequently include a number of draws or incremental funding events, during the renovation stage. In contrast, Lone Oak does not fund any construction draws, even if the borrower is renovating the subject property. The advantage Lone Oak enjoys is a simpler business that allows it to manage more money with fewer employees. The advantage for Arixa is that it knows its borrowers and projects intimately, and its borrowers tend to add a great deal of value to the properties Arixa lends on, so that the lender’s margin of safety increases over time.

Dynamics in a Downturn

Investors need to understand the impact of economic cycles on the returns of private debt funds. It’s important to distinguish between the factors behind an economic downturn. In the economic crisis of 2008/2009, real estate values plunged, quickly subverting the economics of short-term real estate improvement or construction loans. As noted in this paper, lenders aim to maintain loan-to-value ratios that provide a substantial cushion against any price drops, with LTVs typically in the 65-75% range. As a result, the better private debt fund lenders tended to generate flat to slightly positive returns at the height of the Great Recession. 

Anchor Loans is one example, having made more than $7 billion in private debt fund loans in the past two decades in 47 states. The lender focuses on renovation loans on single family homes (with 1 to 4 units) and finances speculative (“spec”) construction. While the firm has generated annual returns for investors in excess of 9% since 2010, Anchor also managed to break-even in 2008/2009.

Anchor deploys various mitigation controls to reduce or eliminate risks, including conservative loan-to-value ratios, a focus on repeat business to establish a long-term track record with existing clients, and structuring loans as “blanket loans,” which compels clients to place all open loans under one agreement so the client isn’t in a position to declare a default on just one loan.

Fast forward to 2020, and a very different backdrop is in place for real estate, even as the broader economy endures a profound contraction. That’s because real estate lending practices never grew out of hand in the slower-growth economy of recent years. Banks maintained tighter lending standards while homeowners and building owners have maintained more substantial levels of equity in their properties. 

“This economic downturn is very different, and far less risky than the last one, which is why Anchor is maintaining but not tightening its lending standards,” says Anchor CEO Steve Pollack. “There is now much more equity in real estate than before, and banks have also been generally more prudent,” and as a result, “we haven’t paused our lending.”

While Anchor didn’t see a huge impact from COVID-19, lending activity in general saw a slowdown. Industry research firm Preqin found that U.S. commercial real estate activity slowed in the summer of 2020. “Just $7.3 billion of private equity real estate deals were completed in Q2 2020 up to June 15th, compared with $31 billion in Q1.” The researchers added that “with $147 billion of dry powder waiting to be deployed in US commercial real estate, the market is poised to return to action as it emerges from this crisis.”

Offsetting an otherwise cautious economic backdrop, a low interest rate environment provides support to real estate asset-based lending. Yet it is fair to wonder how such an approach might fare in a rising rate environment. If interest rates increase, there will be fewer potential buyers/borrowers, and some private debt fund clients may need to hold on to their properties for a little longer than they anticipated. “The experienced flippers know how to navigate these environments, for example, by adjusting their sales prices to exit their investments in reasonable time frames,” says Pollack. Nonetheless, loan volumes for Anchor would fall. 

In such a scenario, it would be crucial for investors to focus on private debt fund managers that maintain the same level of lending discipline across economic cycles. Some firms may be tempted to lower lending standards to maintain the volume of loan origination, yet that would likely lead to lower quality loan portfolios and more loan losses.

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Summary of Rewards & Risks

Private debt funds can offer attractive income and non-correlated returns. Investing in these funds does require due diligence, but this effort can pay off for investors and their advisers. Please refer to Appendix A for a full overview of the summary of rewards and risks.

About the Authors

Jan Brzeski

Jan Brzeski

Managing Director & Chief Investment Officer / Arixa Capital 

Jan Brzeski founded Arixa Capital, one of the West Coast’s most active private real estate lenders providing small balance bridge and renovation loans to lower middle-market residential investors and developers. Since starting Arixa in 2006, his firm has originated approximately 1,700 real estate loans, investing over $1.7 billion on behalf of Arixa’s fund investors. Jan earned a bachelor’s degree in physics from Dartmouth College, and a master’s degree in philosophy, politics & economics (PPE) from Oxford University. 

David Sternman

David Sterman 

Editor and Contributor | President & CEO / Huguenot Financial Planning

David Sterman founded Huguenot Financial Planning in 2018 to fulfill a long-standing goal of empowering consumers as they prepare for a prosperous future. Previously, he worked as a research analyst on Wall Street and also as a financial journalist, as Director of Research for Individual Investor magazine, Managing Editor at RealMoney.com and Chief Market Strategist for StreetAuthority, LLC. David earned a dual bachelor’s degree in philosophy and political science from Emory University, and a master’s degree in the science of management from Georgia Tech. David also holds a CERTIFIED FINANCIAL PLANNER™ certification.

Acknowledgement

The authors wish to thank Maggie Lin who acted as project manager for this white paper; Joana Oliveira, designer; and the industry experts whom we interviewed: Seth Davis, Jerry Ducot, Laura Frega, Allen Kim, Meghan Pinchuk, Steve Pollack and Maier Rosenberg.

 
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