We all know the importance of diversification in an investor’s portfolio. The American Association of Individual Investors recommends that bonds should account for between 30 percent and 50 percent of the portfolios of all but the most aggressive investors. Moreover, many advisors recommend that 5 percent to 10 percent of investors’ portfolios be allocated to alternative investments, such as commercial real estate. However, the vast majority of investors are underweighted in categories such as real estate and high-yield fixed income products.

Again, investors are hard-pressed to find products that produce significant income without a large amount of risk in the current low interest rate environment. Investments that protect capital, such as government bonds or money market accounts, also provide razor-thin yields. Growth in personal wealth since the recession has largely come from the equity market, which has had a remarkable run-up in recent years, leaving many investor portfolios overly skewed toward equities and badly in need of rebalancing.

Risks

Investing in a mezzanine debt fund can help solve multiple issues: It can provide diversification, add exposure to underweighted sectors and boost current income. Like all investments, though, mezzanine lending comes with risks. One is interest rate risk, since an increase in Treasury yields would reduce the value of a debt fund.

Investors have been warned about the prospect of rising rates for several years, but it increasingly appears that rates will remain low for an extended period because the conditions that produced them are unlikely to waver in the near future. Demand for U.S. government-backed securities is robust from non-U.S. investors who are seeking stability while much of the world faces economic or political uncertainty. Meanwhile, despite signs that the U.S. economy is picking up, income growth remains weak, and there remains a persistently high number of underemployed workers.

Another risk involves a downturn in real estate performance. If demand for commercial space, such as offices, apartments and malls, decreases due to a weak economy, technological advances or some other factor, that could lead to rising vacancies, reduced property income and increased risk of defaults.

There are factors at work to prevent this from occurring. The financial crisis led to increasing vacancy rates, but it also shut down the supply of new construction. Each property type and each market has its own dynamics, but in general over the past few years, commercial space has slowly been absorbed and rents are now slowly increasing amid very little supply in most sectors. With banks staying cautious, speculative construction is rare. The one sector in which construction has returned to historical norms is apartments, but that is a response to record-low vacancy rates and a severe shortage in many markets.

There are segments of the market that may be over-valued, such as central business districts in major metropolitan areas and certain urban and suburban multifamily properties. But for the most part, the commercial real estate market is in a period of slow recovery, with few signs of overheating.

Because it is so specialized, advisors who explore the sector for their clients need to focus on these characteristics when selecting a mezzanine fund and fund manager: