Taking out a loan for a real estate investment may seem tougher than ever—especially for those new to the game. In the wake of three bank failures, rising interest rates, and a contraction of credit among lenders, clearly there are additional challenges in today’s market. In early 2023, Silicon Valley Bank collapsed, followed closely by the falling out of Signature Bank and then First Republic Bank, as reported in the Financial Times. In May, the Federal Reserve announced increased rates from 5% to 5.25% in an effort to tame inflation and spur job growth.
That said, debt typically takes up a portion of the capital stack and is often necessary to acquire a property. Once you’ve found a great opportunity, you’ll usually gather two main types of equity, known as preferred equity and common equity (I explained how these work in a previous article). The capital stack also includes layers of debt, which we’ll look at in depth here. These are senior debt and mezzanine debt, and it’s important to both understand what they are and how today’s lending environment could impact your financing activity.
Sourcing Senior Debt
Banks and lending institutions issue this type of debt, which is secured by a mortgage, or a pledge of the property. Senior debt could also be available from insurance companies and CMBS markets. (CMBS stands for commercial mortgage-backed security.) If payments are not made, the lender typically retains the right to take over the place through foreclosure. They can then resell the property to recoup their expected return.
Senior debt takes the bottom of the capital stack, as it has the lowest risk. Lenders will be paid first, before mezzanine debt holders and equity investors. Senior debt also has the lowest opportunity for rewards, as the interest rate will be established and is typically lower than what mezzanine and equity participants will receive.
Sourcing Mezzanine Debt
In the capital stack, mezzanine debt falls into place in the middle, below common and preferred equity, and above senior debt. It is a hybrid lending tool that serves as a bridge between the debt and equity portions. It acts as a secondary loan against the ownership of the property. This type of financing could come from sources such as a family office or another privately negotiated transaction. Mezzanine debt lenders generally expect to receive regular payments at an interest rate that is higher than the senior debt rate. They usually hold the right to convert the debt into an equity interest if the borrower defaults on the loan.
In terms of payments, the mezzanine debt is serviced after the operating expenses and senior debt. For this reason, it carries higher risk in the capital stack than senior debt. However, it also has priority over preferred equity and common equity. As such, it is generally considered safer than preferred equity and common equity. It also has less potential for rewards than the equity portions of the capital stack.
Debt in Today’s Market
During the past year, banks have been tightening their lending policies for all categories of commercial real estate loans, per the Senior Loan Officer Opinion Survey released by the Federal Reserve in April 2023. The most frequent changes included greater spreads of loan rates over banks’ cost of funds, along with a drop in loan-to-value ratios. (Loan-to-value refers to the loan amount divided by the total value of the property).
That said, U.S. banking officials are recognizing these trends and addressing the stresses of the market. In June, top regulators asked lenders to work with commercial real estate owners who are facing such a difficult environment, as reported in Bisnow. Borrowers with good credit standing may be able to make agreements on loan repayments to accommodate their situations.
Given these trends, investors today can expect the need to bring more equity to the table when acquiring properties. The types of financing available may carry more risk as well. Pay attention to collateral, as personal guarantees could cost you if the unexpected happens. For this reason, I always advise making sure you’re not overleveraging your funds as you enter a deal.
When sourcing debt, a good mortgage broker will be able to bring you lending options and help evaluate what’s available to you. We’ll look at this more in-depth in the next article. With the right plan and financing tools in place, you could be on your way to getting long-term returns that outperform the market.