In today’s low interest rate environment, individual investors face a stark choice: put their money in instruments like equities or junk bonds that offer high return potential but come with high risk or choose less risky fixed-income instruments that generate low returns. Investments that provide healthy dividends and minimal risk of principal loss are few and far between.
There are other alternatives. Commercial real estate mezzanine debt, backed by commercial properties such offices, apartments, retail shops and hotels, is a little-known product that provides substantial dividends without nearly as much volatility as equities or junk bonds.
Mezzanine debt has a long list of virtues. It carries high single-digit to low double-digit coupons, higher than most junk bonds or REITs, and thus is a boon to investors starved for yield. It is backed by hard assets, which provides some protection in the event of default. And it occupies a segment—commercial real estate —in which virtually every individual investor is under-allocated. Moreover, some dubious lending practices that plagued the sector during the early part of the decade have been eliminated, meaning risks are much lower than they were in the past.
Historically, investing in mezzanine debt has been largely the province of institutional investors such as pension funds and sovereign wealth funds, who invest either directly in deals or through so-called opportunity funds, which are commingled pools of money set up to pursue specific strategies. More recently, certain money managers have launched real estate investment funds open to accredited investors that focus on mezzanine debt alongside senior loans. Over the next year, the first “pure play” mezzanine funds open to individual investors are expected to come to market, reflecting the upcoming wave of commercial mortgage maturities and the thirst for yield among investors of all types.
Mezzanine Debt: An Introduction
Mezzanine loans, long a staple of the commercial mortgage market, are used by property owners as a financing tool that is less expensive than equity but more expensive than senior debt. Senior loans typically represent 60 to 65 percent of asset value on a commercial real estate transaction, and mezzanine debt adds another layer of 10 to 20 percent, with equity representing the remaining portion.
The primary advantage of commercial properties over single-family homes is that they generate rental income. The income from tenants is used to pay the senior lender first and the mezzanine debt second, with the remaining portion retained by the equity holder. Careful mortgage lenders typically underwrite loans to ensure that there is more than enough income to service all the debt as well as an equity cushion to support the debt.
A Closer Look
Mezzanine debt is a fixed-income product that produces a consistent dividend yield. Because it is subordinate to the senior loan, the coupon is much higher, although the absolute rate depends on a number of factors, including the amount of leverage, the type and location of the property and the quality of the tenant and the sponsor. Generally, the coupons range from the high single digits to the low double digits.
Mezzanine debt is a “hard asset” investment; in other words, it is secured by the borrower’s interest in the underlying property. This gives investors a greater degree of protection and transparency than in other high-yield products such as junk bonds, which are based on corporate credit. If a mezzanine loan defaults, the lender has the right to seize the underlying property, which has intrinsic value. Commercial real estate loan portfolios also provide layers of diversification: a portfolio of loans encompasses different property types, geographic locations and multiple tenants.