Blog Layout

CRE Back Leverage


The Role of Back Leverage in CRE


Historical / Foundational Context


Historically, banks have been one of the largest debt providers in the commercial real estate (CRE) sector. This changed dramatically during the most recent interest rate hiking cycle, where the Federal Reserve raised the Fed Funds rate from 0% to 5.25% in a relatively short time frame. As a result, regional banks across the country experienced significant pressure, particularly from billions in unrealized losses on their books as changes in the risk and reward spectrum challenged asset values. Banks use funds from depositors to issue loans, which they then hold on their balance sheets or sell to the market (other banks / investors). When interest rates are stable or declining, these loans, considered assets, retain or increase in value. However, when interest rates rise, loans made at lower rates lose value, creating substantial risk for banks.


In addition to originating and holding loans, banks also purchase bundles of loans or fixed-income securities from others. The combination of sharp rate increases and leveraging fundamentals contributed to the collapse of Silicon Valley Bank, Signature Bank, and First Republic in March 2023—marking the third and fourth largest bank failures since 2001. Banks are in the business of borrowing short from depositors and lending long, which creates a potential mismatch between their assets and liabilities when depositors seek withdrawals. With rising interest rates, banks’ balance sheets became impaired by underwater securities, leading to a severe reduction in liquidity—something that the CRE industry relies on to function.


In response, private debt funds emerged to fill the gaps left by regional banks. These funds have grown in number, stepping in to provide capital to the CRE market. However, despite banks originating fewer loans directly to CRE borrowers, they continue to have ways of maintaining market share—chiefly through back leverage.


What is Back Leverage?


Back leverage refers to financing provided to private debt funds, enabling them to enhance their loan originations, acquire new loans, or leverage existing positions. Private debt funds typically borrow capital from third parties—such as banks—to finance these activities. By using back leverage, funds can improve returns on equity by lowering their cost of capital, thus reducing the equity required to fund new loan originations or acquisitions. This financing model allows banks to gain indirect exposure to the illiquid assets that back the debt fund’s loans.

Back leverage gained popularity when interest rates were near zero because it allowed funds to enhance returns at a very low cost. However, as market conditions soured and interest rates rose, back leverage providers reassessed their exposure to potential losses, leading to a more cautious approach. This hesitation resulted in a reduction in the willingness of back leverage providers to extend additional leverage to debt funds.


Goal of Back Leverage


The goal of back leverage is to create a mutually beneficial relationship between fund sponsors (private debt funds) and third-party funding institutions (banks). For the bank, back leverage provides an opportunity to optimize profitability and balance risk through proper structuring. For the fund sponsor, it enables greater returns on equity while increasing their investment capacity.

Achieving the right back leverage structure requires careful balancing of regulatory and tax considerations alongside the sponsor's goal of securing a more cost-effective and diversified capital base. By optimizing the structure of back leverage, both parties can maximize value while managing their respective risks.


Back Leverage Structures


The primary back leverage structures include loan-on-loan facilities, repo agreements, and private securitizations.

Sometimes these structures can be used for transitional assets that require bridge or construction financing. By utilizing master repurchase agreements, a bank can essentially back a sponsor's business plan, providing capital for new loan originations. Typically, the Sponsor approaches the bank to see if they have an appetite to place a loan on their line or books. The agreements outline several financial covenants to effectively manage risk for the third party.


In some structures, loans or assets are transferred to a special purpose vehicle (SPV). The SPV issues a senior note to the bank lender, while the junior note is held by the fund sponsor. This allows the bank to put up less capital, which increases its lending capacity and reduces risk exposure.


Repurchase agreement structures are often more costly, complex, and reserved for larger funds and financial institutions while loan-on-loan structures are easier and more efficient to execute for small and mid-sized fund managers.

In all back leverage structures, the bank and the fund sponsor work together to balance their risks and rewards. Lenders typically include risk mitigation provisions in the agreements, such as mark-to-market terms, loan-to-value (LTV) thresholds, recourse clauses, and margin call provisions. For example, if the net operating income (NOI) of a property securing a mortgage declines, the lender can issue a margin call to adjust the advance rate provided to the fund sponsor.


Impact of Back Leverage on CRE


Back leverage depends on market stability. Lending is driven by confidence in risk assessment, and for the CRE market to function effectively, there must be consensus on risk pricing. Since credit and mortgage flows play a critical role in determining real estate valuations, any significant shift in liquidity can either stall or accelerate investment activity.

In recent years, back leverage took a backseat due to market volatility. However, it is slowly re-entering the market, albeit with increased safety provisions and more cautious decision-making. As banks regain confidence in market stability, they are more likely to offer back leverage facilities to alternative credit providers, which will, in turn, enhance liquidity and contribute to price discovery for real estate assets. It is safe to say we may see a material increase in types and complexity of structures as lenders aim to capitalize on creating value by filling marketplace and capital stack voids.

Fed Balance Sheet Talk

By Christian O'Neal • March 20, 2025
Fed's Balance Sheet - Why It Matters 

Tariffs on CRE

By Christian O'Neal • March 20, 2025
Impact of Tariffs on CRE

Why Residential?

By Christian O'Neal • February 13, 2025
The fundamental need for housing is universal—everyone requires a roof over their head. In the United States, however, we are facing a significant shortage of housing. According to the National Multifamily Housing Council, an additional 4.3 million units will be needed by 2035 to meet growing demand. Much of this demand is driven by migration to expanding lower cost cities and away from high tax, high cost metros, a trend accelerated by the widespread adoption of remote work during the pandemic. This trend has reshaped the housing landscape, creating a compelling opportunity for investors. While there are numerous investment strategies available, each with its own set of risks, residential real estate stands out. Over the past three decades, multifamily rentals have consistently delivered the highest risk-adjusted returns in commercial real estate. Why? Because housing is an essential need, regardless of economic conditions. At AEG, we are strategically developing both for-sale and rental housing, allowing us to adapt our approach to changing market dynamics and maximize returns while mitigating risk. Here’s why we are confident in the strength of residential housing as an investment: Land is Finite: Unlike many other asset classes, land cannot be created or expanded. The supply is fixed, and the demand for housing continues to grow. In the foreseeable future, virtual spaces like the metaverse will not replace the fundamental human need for physical shelter. Residential Housing is Non-Discretionary, and It's Supported by Government Liquidity: Housing is the only non-discretionary asset class. If it weren’t, we would see similar government support for other sectors like retail, office, or industrial real estate, but we don't. The federal government provides liquidity to the multifamily housing market because it is a fundamental need. This support drives down the weighted average cost of capital (WACC), making housing assets attractive to investors. This consistent access to capital compresses cap rates, creating a floor on the market (to an extent), fueling long-term growth and demand from investors big and small. Rents Tract with Inflation, and It is Rare to See Negative National Rent Growth: Rents reset every year as cost increases are passed off to tenants via annual lease contract resets. Since the beginning of recorded history, national rents have only gone negative year over year three times: the Spanish flu of 1918, the Great Financial Crisis, and during the Covid-19 pandemic. While yearly gains in rental cashflow streams will not make you wealthy, they are without a doubt very stable cashflows, historically speaking. There is no similar liquidity for for-sale housing, but its non-discretionary nature still gives it a strong investment profile. In growth markets like South Carolina's tertiary cities, the influx of new residents is fueling demand across all price points, further strengthening the residential sector. We believe in our residential investment thesis for both macro and local fundamental reasons. If interest rates remain high, new construction will slow even further. Meanwhile, homes in desirable locations will remain in high demand as many homeowners—especially those with low-rate mortgages—are unlikely to sell. According to the latest third-quarter data from the FHFA, 73.3% of U.S. mortgage borrowers now have an interest rate below 5.0%, a decline of 12.2 percentage points since Q1 2022. This significant shift in mortgage rates creates a unique dynamic: many homeowners are effectively "locked in" to their current homes, preventing them from moving and creating a looser supply in the for-sale market. As a result, home prices are expected to remain elevated in high-demand areas. While values may remain relatively flat in real terms over the next few years, on a nominal basis, they are expected to rise, particularly in growing markets. If interest rates decrease or economic growth drives up rental demand, build-for-rent communities could become more viable. However, they are not yet penciling out as attractive investments because growth has stalled - but, that is about to reverse. Thanks to our strategy and access to land—often without burdening our balance sheet or stretching our resources—we are able to remain nimble and pivot towards the most attractive risk-adjusted yields. As we navigate an uncertain economic environment, several factors support the ongoing strength of the residential housing market: slow housing starts, higher interest rates, and a large percentage of homeowners sitting on mortgages with sub-4% rates. These dynamics, along with strong demand in high-growth areas, reinforce our belief that residential real estate will remain a compelling investment in the years to come. At AEG, our focus is on developing attainable, high-quality housing, from custom spec homes, to mini-farm tracts, to higher density townhome projects. This flexibility allows us to serve a wide range of income levels and tailor our strategy to market conditions. With a commitment to quality finishes and high end products, we appeal to buyers regardless of economic conditions, providing us with a tighter, more predictable cash conversion and days on market cycle, unlike some of our competitors. By seeking out individually parceled deals, we reduce overall risk and remain agile in our decision-making.
Show More
Share by: