Thanks to rising interest rates, increasing construction costs and climbing property prices, returns in commercial real estate investments have been harder to generate. To produce sure and consistent returns, real estate companies are looking beyond equity and investing in commercial real estate debt.
Banks and other traditional sources of capital, such as insurance companies or pension funds, have historically been primary sources for debt financing. However, increased regulation in the wake of the Great Recession has curtailed the amount, type and level of lending these institutions can do, making them more conservative.
For that reason, commercial loans typically fall short of what equity partners need today. Commercial banks don’t usually lend more than 65% of the full value of the property, and they have also been reducing their exposure to commercial and multifamily real estate. The gap between bank funding and the owner or developer’s funding leaves lucrative openings for investors to fill —the middle of what is called the capital stack.
How Commercial Real Estate Debt Financing Works
With real estate debt investments, investors act as lenders to property owners, developers or real estate companies sponsoring deals. The loan is secured by the property, and investors earn a fixed return based on the loan’s interest rate and the amount they’ve invested. Real estate debt is an attractive investment for several reasons. It offers a wide range of risk profiles to investors, from low-risk loans secured by stable, Class A properties to higher yield opportunistic strategies such as construction loans. For investors who don’t want to tie up assets long term, debt investments can have a shorter holding period than equity investments, with deals usually lasting between six months and two years. And for investors in search of yield, it’s a consistent fixed-income vehicle that produces cash income from the inception of the investment.
Real estate debt investments also offer less risk because equity sits in the first loss position. When a property’s value declines by 10%, the debt investor is still secure while the equity investor bears the entire brunt of the loss. But less risk can also mean less reward; returns are limited by the interest rate on the loan.
How Much Risk to Take? Understand the Capital Stack
The easiest way to understand how commercial real estate projects are financed, whether equity or debt, is to look at the capital stack. It delineates who has the rights to the income and profits a property generates during its hold period and when it is sold.
The capital stack goes from the riskiest type of debt financing option at the top to the most secure at the bottom. Each level of capital has seniority over everything stacked above it, so when a property is sold or refinanced, the bottom position is fully repaid first. If there are insufficient funds to repay any level of debt, the losses are incurred from the top down. The most commonly used types of real estate debt, from the bottom of the capital stack to the top, are as follows:
Senior secured, or unsubordinated, debt: Senior debt, the foundation of the capital stack and typically the largest part of the stack, is usually a mortgage secured by the property. It is also called a senior secured loan and a first lien loan; lenders who own the first mortgage on a property owns the first lien. Nonpayment gives lenders the right to force the sale of the property to pay the obligation, which makes this the most secure type of debt. But with that security comes a lower (and in fact the lowest) level of reward in terms of interest rates compared to higher layers in the capital stack. Typically, senior loans have floating rates priced above a benchmark rate such as the London Interbank Offered Rate, or LIBOR. For example, a loan priced at 200 basis points above LIBOR when it’s trading at 2.2% would have an all-in rate of 4.2%.
Mezzanine, or subordinated, debt: These loans sit on top of senior debt, which makes it subordinate to mortgage debt—it gets paid after all senior debts have been satisfied. Mezzanine debt, also called mezz debt, bridges the gap between bank loans and shareholder equity. Once a developer or owner pays the senior debt and operating expenses, all income must go to pay mezzanine debt next. If payments are not met, the mezzanine financing investor has the right to foreclose out the equity position and potentially take over the property and the mortgage. Returns on mezzanine debt in the real estate space are typically between 8% and 14% depending on the risk of the project and how much equity is being brought to the table by the sponsors. Our IncomePlus Fund is made up of 25% mezzanine debt.
Preferred equity: While preferred equity gives investors in a real estate venture the right to be paid before common shareholders, it’s very flexible. Its terms can range from “hard” preferred equity, which is similar to mezzanine debt and can offer investors the ability to make some decisions (or even kick out or an owner or developer if they fail to make payments) to “soft” preferred equity, which may include some financial upside if a project does well but has more limited rights. Offering documents specify the parameters of the preferred equity’s rights and its shares’ rate of return, and once all debts are paid preferred shareholders can claim profits until they meet the targeted amount before common equity holders. Since this has seniority to common equity, its expected risk and the potential reward is slightly lower than common equity.
Common equity: At the top of the capital stack, common equity offers the investor an ownership stake in a property. It has the greatest risk because owners are repaid only after all the other lenders in the capital stack are repaid. But it can also offer the greatest rewards; to compensate for the increased risk, equity investors receive 100% of a project’s upside, and if a project does well that can amount to a significant sum of money. Usually, a project’s developer or owner earns a disproportionate share of the upside even within the common equity group. The limited partners might provide 90% of the equity buy only get 75% of the upside. This aligns interest and is meant as an incentive to outperform. It also enables the sponsor to leverage their capital further within the partnership structure.
Ultimately, investors must be clear about whether they’re willing to sacrifice the potential to earn higher yields in exchange for a safer bet. Commercial real estate debt investing can generate returns on a risk-adjusted basis that compare favorably against expected equity returns, but with debt risk characteristics and benefits. A mix of equity and debt investments has the best potential for balancing risk and reward in a real estate portfolio.