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Four ways to potentially enhance returns through leverage

March 11, 2025 | 2 min read
Kirloes Gerges
Managing Director, Portfolio Management, Principal Real Estate Debt
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AT-A-GLANCE

  • There are a variety of ways to finance senior mortgage loans. Using 100% debt fund equity is always an option, of course, but utilizing leverage enables more output for a given input – in other words, potential enhanced returns.
  • Most debt fund and mortgage REIT managers in today’s senior mortgage space utilize leverage in order to potentially enhance returns.
    • There are broadly four types of leverage commonly utilized: Note-on-note financing and warehouse/REPO facilities are forms of third-party leverage, which involves borrowing against equity to enhance returns.
    • A-note sales and commercial real estate collateralized loan obligations (CRE CLO) are forms of structured leverage, which involves carving up the loan or portfolio, divesting the most conservative position(s) and retaining the less conservative position(s) for a higher yield.

Leverage is a strategy designed to enhance an investment’s returns. In this paper, we explore leverage with a focus on one piece of the capital stack: senior debt in the transitional space. These are first mortgage loans secured by properties that are currently in or will soon be in a state of transition. They provide sponsors shorter-term financing to facilitate property acquisitions and repositioning.

EXHIBIT 1: Four ways to enhance returns though leverage

Table showing four ways to enhance returns through leverage

Third-party leverage

Third-party leverage involves using a combination of equity and borrowed money to potentially enhance returns, which come from the difference between the fund yield and the interest on the financed portion. In this paper we cover two types of third-party financing structures: note-on-note and warehouse facilities.

Note-on-note financing

Note-on-note financing involves financing a mortgage where the mortgage note is the collateral. Essentially we’re borrowing some amount (the advance rate) supplemented by debt fund equity in order to make the investment. Many large financial institutions, including investment banks, money center banks, regional banks and some insurance companies, offer this type of program.

EXHIBIT 2: Note-on-note leverage example

Two examples of note-on-note financing one with leverage and one without leverage
Note: For illustrative purposes only. Calculations assume secured overnight financing rate (SOFR) at 4.00%.
 
The value of note-on-note leverage is the same principle as any kind of third-party leverage – higher net earnings on levered investments than non-levered investments. Consider the example shown in Exhibit 2. We could do an all-equity deal. If our coupon is 350 basis points (bps)* above the benchmark (SOFR), then our annual return on the debt fund equity is 6%. Alternatively, we could leverage $25 million in equity to borrow $75 million (a 75% advance rate). We earn the same 6% on the loan; subtracting interest at SOFR plus 250 basis points, our return on the debt fund equity is 9%.
 
*A basis point is a unit of measure used to indicate percentage changes in financial instruments.

Conclusion

There is a wide range of considerations to be made when deciding how to utilize leverage in order to potentially enhance returns. The key is having an investment partner with deep experience and expertise doing just that. Principal Real Estate is a top-ten global real estate manager with over $22 billion in real estate debt AUM and 60+ years of private debt experience . Having facilitated more than $124 billion in real estate debt and equity transactions over the past decade, we understand well how to use leverage to strive to enhance returns.

Footnotes

Managers ranked by total worldwide real estate assets (net of leverage, including contributions committed or received, but not yet invested; REOCs are included with equity; REIT securities are excluded), as of 30 June 2024. “The Largest Real Estate Investment Managers,” Pensions & Investments, 7 October 2024. As of December 31, 2024. Experience includes investment management activities of predecessor firms beginning with the investment department of Principal Life Insurance Company. Principal Real Estate became registered with the SEC in November 1999.Activities noted prior to this date above were conducted beginning with the real estate investment management area of Principal Life Insurance Company and later Principal Capital Real Estate Investors, LLC, the predecessor firm to Principal Real Estate Investors, LLC. As of December 31, 2024. Excludes public REIT transaction volume.
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Disclosure

Risk Considerations

Investing involves risk, including possible loss of Principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate.

The use of leverage increases investment exposure and has the potential to magnify losses. Investments in leveraged loans, middle market loans, and mezzanine debt, second liens, are subject to various risk factors, including credit risk, liquidity risk and interest rate risk. Commercial mortgage lending entails a degree of risk that is typically for those who can who fully understand and can bear the risks associated with such strategy. Any commercial mortgage is subject to the basic risk of lending and direct ownership of commercial real estate mortgages - borrower default on the loan and declines in the value of the real estate collateral. Defaults can be complicated by borrower bankruptcy and other litigation including the costs and expenses associated with foreclosure which can decrease an investor’s return.

Leverage exhibit examples are presented for discussion/demonstration purposes only and are not a projection of returns to any investor. There is no guarantee that any investment strategy will achieve these results. The actual results may differ materially from that depicted above based on numerous factors, including market changes. There is no guarantee that any future transactions entered will have the characteristics like the deals profiled above. Terms, conditions, fees, expenses, pricing and other general guidelines and provisions are subject to change.

Important information

This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account.

Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided. All figures shown in this document are in U.S. dollars unless otherwise noted.

This material may contain ‘forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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MM14358 | 02/2025 | 4227354 -022026
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