The View From The Mezzanine: Looking Into Real Estate's Higher Returns

Posted by Nick Thompson on Aug 20, 2020 10:49:21 AM

5 Minute Read

Many RIA clients are seeking yield, but leery of descending to the lower-rated segments of the corporate debt markets to find it. Commercial real estate mezzanine debt may offer a solution. Here’s why:

• Yields typically are higher than other credits with roughly comparable risks.
• Cash flow, not credit ratings, determine yields.
• Mezzanine financing is a standard component of most deals, accounting for 5% to 25% of the capital structure.
• Mezzanine loans can come with property rights.



The current yield draught

For registered investment advisers, today’s world of ultra-low interest rates poses a challenge: Where can their clients find yields that are more than tissue-thin? Of course, several corporate debt markets offer higher yields, but typically through issues where creditworthiness may be a concern.

A misunderstood solution
Since cash flow, not credit ratings, largely determine yields in commercial real estate, debt instruments backed by real estate often offer attractive returns for the risk profile. This is particularly the case with subordinated, or mezzanine, debt — an area that is frequently misunderstood and therefore avoided. But when its opportunities and risks are clearly understood, subordinated debt can be a reliable source of yield for high-net worth RIA clients.

Mezzanine debt’s role

Of course, as the name implies, mezzanine debt is in the middle. Sitting between equity and senior debt in the capital structure of real estate deals, subordinated debt serves to fill a gap for developers. Instead of having to come up with all of the equity to purchase a property after arranging mortgage financing secured by the property and covering about 60% to 65% of the price, a developer may issue debt subordinate to the senior mortgage debt. In commercial real estate deals, mezzanine debt can account for between 5% and 25% of the capital structure.

“For advisers seeking yields for their clients that are more substantial than those available currently in corporate debt markets, and with a risk profile they may find appropriate, subordinated commercial real estate debt could be something to investigate further.”

Risks

Since there is no free lunch in investing, the reward potential of subordinated real estate debt comes with risk. The main risk, of course, is whether the borrower — in this case the equity owner or owners — will be able to pay interest and principal to mezzanine lenders after satisfying the primary obligation to senior debt owners. Many holders of mezzanine debt were battered in the wake of the 2008 financial crisis when real estate values dropped and credit markets froze. But throughout the decline and recovery, mezzanine financing didn’t disappear because real estate deals continued to take place, developers still had a need for subordinated debt, and savvy investors knew how to look for security and quality.

A unique safety feature

One risk-mitigating aspect of mezzanine loans that careful investors scrutinize are the pledges made by borrowers. Unlike the property liens that are a component of senior debt, mezzanine loans are backed by a pledge of some or all of the equity interests in the legal entity that holds the property title. As a result, if a property owner defaults, mezzanine loan investors don’t pursue the property’s foreclosure, which often is the action taken by the first-mortgage holder, but rather they foreclose on their equity in the company that holds title to the property. The process may not be speedy, but when the title eventually passes to them, mezzanine debt investors wind up owning the shares that own the property.

The value of knowledge market participants

That’s where a financial intermediary with deep roots in real estate can be of value to RIAs and their clients. As part of the Forum Investment Group, which oversees a $2 billion largely multi-family commercial real estate portfolio in 18 states, Forum Capital Advisors has the market knowledge and breadth of relationships to satisfy the most demanding gatekeepers and investors. In addition, along with being an investor in Forum’s funds, our multi-national institutional investor’s fixed-income group acts as the funds’ subadvisor, providing due diligence support.

For advisers seeking yields for their clients that are more substantial than those available currently in corporate debt markets, and with a risk profile they may find appropriate, subordinated commercial real estate debt could be something to investigate further.

Learn More About Our Investments

 

Nick Thompson – Senior Managing Director
nthompson@forumcapadvisors.com

As Senior Managing Director of Forum Capital Advisors, Nick is responsible for leading Forum’s investor client acquisition and capital raising efforts on behalf of all business within the Forum companies.

 

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Topics: Real Estate Investing, Real Estate Debt

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