The commercial real estate industry is broad, featuring multiple asset types as well as both debt and equity opportunities. Many investors choose to make common equity investments, but don’t take advantage of real estate debt investments.
Commercial real estate debt investments can be made in senior loans or mezzanine loans. Mezzanine debt can provide investors with a balance between investing in a collateral-backed investment while still achieving higher yields compared to senior loans.
New models of real estate crowdfunding have made it possible for the modern real estate investor to easily build a real estate portfolio with both equity and debt investments. Investors should take the time to understand the different types of opportunities available to them, including mezzanine debt and common equity investments, and the risk and return profiles of each variety. This knowledge may allow investors to take advantage of different parts of the capital stack to attain a more diversified portfolio.
Benefits of Mezzanine Debt Investments
Mezzanine loans have several benefits, including:
- Steady cash flow from interest payments paid by the borrower
- Higher yields than senior debt investments due to higher interest rates paid by the borrower
- Has priority of repayment before common equity since all debt service is paid before equity investors receive any cash flow
- Secured by a pledge of the ownership interest in the property owner, giving the mezzanine debt holder the ability to foreclose and take over ownership of the property-owning entity in the event of a default by the borrower
Benefits of Common Equity Investments
Common equity investments have several benefits, including:
- Greatest upside potential compared to other types of investments in the capital stack
- Appreciation and growth of property value in a portfolio
- Distributions from property cash flow
- Potential tax breaks and deductions
Why Real Estate Investors May Include Both Debt and Equity Investments in Their Portfolios
Diversification is a well-known tool that investors often use to reduce their exposure to market volatility by including a variety of assets in their portfolios. With proper diversification, the impact to the overall performance of a portfolio could be reduced in the event of any adverse effects to a particular asset within that portfolio.
When a real estate asset class is performing well, a common equity investment could potentially yield strong upside through property appreciation, assuming, of course, that the deal has strong fundamentals, solid underwriting and an experienced sponsor at the helm.
Nonetheless, there are times when that same asset class can enter into a slump as a result of macro or microeconomic events. When that asset class no longer performs well, that same common equity investment may be at the greatest risk of losing value as it’s in the first-loss position in the capital stack.
Debt investments, including mezzanine debt, are less susceptible to changes in performance as a result of market impacts. While mezzanine debt borrowers may default on a mezzanine debt investment, the debt holders have collateral to pursue (as described above), which can result in a full recoupment of the investment made, and in some cases a windfall.
Additionally, many equity investments provide their largest returns to investors upon a refinancing of the debt or a sale of the property, but may not generate consistent cash flow. This is typically the case in ground-up developments or value-add projects with high capital needs. Mezzanine debt, while generally yielding lower returns than equity investments, may produce consistent cash flow. This is because debt holders expect to receive debt service payments from the borrower every month (whether or not the asset is performing well).
Both common equity and mezzanine debt investments have benefits and attributes that make them desirable. Common equity investments can provide long-term appreciation, certain tax benefits and strong upside potential. Debt investments, including mezzanine debt, can provide insulation from economic downturns, consistent cash flow, and potential recourse if the deal does not go as planned.
This is why some investors include both investment types within their portfolios. Mezzanine debt in particular could provide appealing risk-adjusted returns because it typically has higher yields than senior debt with a more protected position than common equity.