Unlocking capital: How debt fund lenders are using back leverage in real estate lending

Back leverage is increasingly becoming a hot topic in the real estate finance sector.

According to a recent report by Knight Frank, Behind the Stack: The Rise of Back Leverage in Commercial Real Estate Debt, £100 billion of capital has been raised through back leverage structures, with 80% of debt fund managers planning to use back leverage in the next 12 months and 90% of banking respondents believing this type of financing will ultimately become market standard. 

Speaking to author and back leverage expert Jess Qureshi, she told us that “back leverage has become a widely used strategic tool in commercial real estate, especially as the lending market has diversified. Today, asset managers have more options in terms of how they achieve their target returns, particularly as we start to see more senior lenders becoming active in back leverage lending”.

Before we explore how back leverage benefits debt fund lenders and how it is typically structured, we should first clarify exactly what is meant by the term “back leverage”.

What is back leverage?

Instead of fully funding real estate loans to borrowers with equity, debt fund lenders borrow funds from a third-party provider – typically a bank – which are then used to fund the loans.

What are its advantages?

Back leverage allows the debt fund to:

1. Offer attractive pricing and increase lending capacity without solely relying on its own capital or uncalled capital from limited partners
2. Enhance its returns by borrowing at a lower cost than the equity commitment to the fund
3. Allow capital to be redeployed into new deals and diversify its lending portfolio by spreading risk across different assets and sectors
4. Access higher value transactions that might otherwise require multi-bank syndication

How is back leverage structured?

There are two main structures.

In a standard loan-on-loan structure, a debt fund lender establishes a special purpose vehicle (SPV) to act as the lender of record. The SPV then issues a loan to the borrower. To finance this loan (or a portfolio of loans), the SPV borrows from a back leverage provider, typically a bank, using the cashflows received from the borrower to service the back leverage debt.

The back leverage provider benefits from an all-assets security package granted by the SPV lender. This includes security over all the SPV’s rights under the underlying loan, including any security interests the SPV itself received from the borrower.

Alternatively, back leverage can be employed with the use of a repo structure. Under a repurchase agreement, the SPV lender will sell a loan or portfolio of loans to the back leverage provider, with a simultaneous agreement by the SPV lender to buy back the loans on an agreed date, at an agreed price, effectively repaying the loans. Available agreement templates include the Global Master Repurchase Agreement (GMRA) or the New York law governed Master Repurchase Agreement (MRA).

Loan-on-loan structures are most popular in the market, according to Knight Frank’s report.

What wider benefits could back leverage bring?

The commercial real estate market is widely seen to be experiencing a ‘refinancing gap’, a shortfall between the amount of debt that needs refinancing, and the amount lenders are willing or able to provide under current market conditions, which has been caused by a general decrease in commercial property valuations noted since 2018 and higher borrowing costs.  Back leverage could therefore provide much needed capital for debt fund lenders to inject liquidity into the commercial real estate market across different assets and sectors.