In debt fund management, fund managers walk a fine line between maximizing returns and managing risk.
Lending money may seem straightforward, but ensuring the safety of investor capital while driving high returns requires a detailed understanding of risk mitigation. Fund managers can protect their investments and achieve sustainable growth through smart underwriting and disciplined project management.
To gain expert insights, we turned to Edwin Epperson, a seasoned debt fund operator and fund manager of the customizable Blue Bay Fund I LLC, to share his strategies for balancing risk and reward in debt fund investments.
[Edwin is a seasoned debt fund manager with extensive experience in deploying investor capital through reduced-risk loans secured by real estate. He specializes in first-position lending and actively participates in purchasing properties for fix-and-flip projects, as well as short- and long-term rentals. Passionate about creating positive impact through investments, Edwin emphasizes the dual goal of achieving strong returns while supporting community initiatives.]
Understanding the Borrower
The first critical step in risk mitigation is assessing the borrower. Their creditworthiness, financial situation, and most importantly—their experience with real estate investments must be thoroughly evaluated.
Edwin highlights the importance of borrower experience, stating, “Until they have completed, meaning they’ve bought, renovated or built, and then sold, at least five projects of a similar kind, they do not have the experience to go forward confidently and be able to confidently estimate risks. Therefore, I consider someone who has completed 5 projects or less still new to the space.”
The more experienced the borrower, the better equipped they are to handle unforeseen challenges, increasing the chances of a successful outcome.
At times, borrowers may not have the necessary experience, but they can compensate by hiring an experienced general contractor. While this reduces risk, it is crucial to vet the contractor’s track record and licensing carefully to ensure they are equipped to manage the project.
Geographic and Political Factors
Location plays a significant role in real estate investments, affecting both risk and future returns. A property’s geographic location must be analyzed not just from a market perspective but also from a political one.
As Edwin asserts, “Politics do play a role in real estate… the political laws, the way they are running their state or city, it’s going to determine the future value of your property.”
For example, properties in highly regulated or politically unstable regions may carry more risk, as government interventions or policy shifts could affect the investment’s outcome.
In addition, fund managers should assess environmental risks such as hurricanes in Florida or earthquakes in California. These are realities that can significantly impact both the property and its marketability, so evaluating the likelihood of natural disasters in the area is essential for weighing the potential rewards against these risks.
Evaluating the Project
For debt fund managers lending on properties being renovated or built, the quality of the project is paramount. Newer managers may lack experience in fix-and-flip projects or construction, which introduces significant risk.
Edwin suggests leveraging third-party experts to perform feasibility studies, which “significantly protect the fund manager because they provide clarity on whether the project scope and costs are in line with the market reality.”
A feasibility study, paired with detailed scope-of-work and line-item budgets, gives lenders an accurate picture of the work to be done and its potential success. This ensures that any capital lent will be used appropriately and effectively.
Managing Construction Draws
One of the biggest mistakes a fund manager can make is releasing too much capital to a borrower upfront. Edwin shares a cautionary tale: “I had an investor take the initial draw money—about $70,000—and instead of starting the projects, he took it to Vegas. We had to foreclose on all three properties.”
To prevent such situations, Edwin stresses the importance of a draw schedule and only releasing funds after work has been completed and inspected.
The draw schedule helps keep borrowers accountable. Lenders should insist on project inspections to verify progress before releasing funds, ensuring that capital is not misused.
As Edwin advises, “Never give the borrower money at closing. Make them put their capital into the project first.”
This system places the burden on the borrower to demonstrate commitment and follow through on the project before additional funds are dispersed.
Using Inspection and Feasibility Reports
A fund manager’s best ally in managing construction risk is the feasibility study and draw inspections. By using these tools, managers ensure that work is being completed as planned and that budgets are realistic.
According to Edwin, “Whatever the inspector says has been completed, that’s what we disburse. At the end of the day, most real estate investors are not professional bookkeepers, so we rely on inspections to safeguard our capital.”
Regular inspections and ongoing assessments of the project’s financial health can prevent lenders from overcommitting or funding incomplete work, minimizing exposure to loss.
Summary
By ensuring that the borrower has sufficient experience, understanding the political and geographic risks of the property, and maintaining tight control over how and when funds are dispersed, fund managers can protect their investments while driving the best investor returns.
Learn More: To Debt Or Not To Debt: Should You Start A Debt Fund?
Ready To Start Your Debt Fund?
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To learn more about how an Avestor can work with you on your new debt fund, schedule a free strategy call with our team at www.avestorinc.com/demo
