Types of Real Estate Debt

In order to generate higher returns, real estate companies finance a portion of its investment using some form of debt. The amount of debt can range from a conservative 40% (typically for less risky investors such as REITs) all the way up to 75% (typically for risky investors such as a development companies).

​The basic types of debt are:

• Senior secured loans
• Mezzanine / subordinated loans
• Construction loans
• Preferred equity

Senior Secured Loans (i.e Mortgages)

This is the most basic and safest (from a lender's perspective) form of debt. These loans are secured by the property itself. In other words, if you fail to make your monthly mortgage payment, the bank has the right to possession of the real estate. Rarely will banks lend more than 60% of the property's value (this is called "loan-to-value" or "LTV"). This ensures that if you default on your payments, there will be enough value in the property to cover the loan.

Because the note is secured, it caries the lowest interest rate. However, a major drawback of a senior note is that it can carry fairly restrictive covenants.

Mezzanine / Subordinated Loans

A mezzanine loan a hybrid of senior debt and equity. Typically this type of financing is used when an investor needs to fill the gap between a senior loan and the borrower's equity. In other words, if the bank will lend 60% but the investor only has 20% equity, a mezzanine loan will fill the 20% gap.

Mezzanine debt is subordinate to senior loans but senior to equity holders. As a result of the higher risk, the interest rate will be substantially higher than senior debt. Mezz loans are attractive because they:

1. Have the potential to enhance equity returns and
   
2. Are less restrictive than senior loans
   

Mezz loans reduce the amount of equity required and have a is lower cost of capital than pure equity. As a result, the investor can be more competitive on pricing due to the lower weighted average cost of capital. 

Construction Loans

Construction loans are used to help fund the entire construction process including hard and soft costs. Typically, the developer will contribute 20% of the required cost to construct the building and the construction loan will make up the rest. However, the equity must be fully used first before the bank will start dulling out money.

Most construction loans will have two parts:

1. The first is a short term loan that is used for the the construction and lease up phase of the project. Once the project is stabilized, the loan is converted to longer term financing (called "mini-perm").
2. A mini-perm loan is shorter in duration than traditional permanent financing, typically maturing in three to five years.

Loan proceeds are disbursed monthly based on draw requests for costs incurred. The big risk of a construction loan (from a bank's perspective) is that there is no property operating history to underwrite. The entire valuation of the property is based on the real estate proforma. Therefore, an investor will have a much easier time securing a construction loan when it has a track history of successful projects.

Preferred Equity Investment

Preferred equity investments are very similar to mezzanine loans but are not technically considered debt. The investment is structured such that the preferred equity provider receives a direct or indirect ownership interest in the real estate. This entitles the preferred equity provider to a preferred or priority return on its investment over the real estate investor. It has aspects of a loan because 1) it typically charges interest on the investment to be paid or accrued monthly, and 2) the entire investment is required to be paid when the property is sold. Although this form of investment is not technically debt, most secured lenders will consider it a form of mezzanine debt and as such will ensure that they are fully protected (i.e. throw in additional covenants).

Check out our Real Estate Career Guide for even more information on the different types of real estate debt!