Just like getting a mortgage from the bank to finance your residential property, Commercial Real Estate Debt can also help developers and investors with their business goals. The main purpose of this loan from borrowers is to increase the capital available for investment and to help them diversify their investments. Without a fully functioning debt market, many investors would be unable to unlock development opportunities and the built environment would suffer from a lack of upgrades.
Whereas many market participants cite ‘higher returns’ as the main purpose of gearing (adding debt to) real estate investments, what we should also realise is that gearing can markedly increase their risk profile. Higher risk-adjusted returns may be possible, specially in the current scenario of low interest rates, but risk should not be overseen in the investment appraisal.
Sources of debt:
Private Debt Market
The private debt market lends directly to the borrower without the stock exchange as an intermediate channel. Without the supervision and regulations from a stock exchange, the private markets offer more flexibility and customisation. The main providers of debt finance in the private debt market are:
- Insurance Companies
- Pension Funds
- Debt Funds
- Hedge Funds
- Peer to Peer Lenders
Public Debt Market
The public debt market is accessed through the stock exchange. In the UK, this is the London Stock Exchange. As stock exchanges are highly regulated trading platforms, they offer more transparency and liquidity for the investors and therefore more reporting requirements but also lower rates for the borrower. Securities in the public markets can be bought and sold daily. For the borrower, the way to access the public debt market is by issuing corporate bonds.
Types of loans
The main types of Commercial Real Estate Debt include:
- Senior Debt / Loan: This is the most secure of all loans because it has priority of payments, and it is the last tranche to absorb the losses and usually have an LTV (Loan to value) of 40 – 60%
- Whole Loan: This is usually a combination of the senior and mezzanine loans and will take leverage up to 60 – 90%. The benefit is that the borrower deals with one counterparty only which facilitates and speeds up the underwriting process.
- Junior Loans: These are subordinated loans which will be serviced once senior interest and any required amortisation are paid to the senior lender. The surplus from the property income will then be used to repay the junior through a cash flow waterfall. Because of the higher risk, these loans have a higher interest rate.
- Mezzanine finance: Mezzanine of ‘mezz’ is a loose term which is often referred to junior loans or preferred equity (which will be covered in our next blog). Mezz has become a common feature in the capital structure of many real estate investments since the Global Financial Crisis (GFC) of 2008-2009 as many banks lowered their LTV offering. Mezz is therefore used to plug in the ‘funding gap’ between senior debt and common equity.
- Syndicated Loans: A syndicated loan is that which will be provided by a group of lenders to a single borrower thereby reducing the counterparty risk to each individual lender. In syndicated loans, there is typically a lead bank or underwriter which may put up a bigger share of the loan and it may perform administrative duties such as distributing the cash flows among the syndicated parties.
Interested in Debt Structures? Join us on our next course in Real Estate Debt Structures & Financial Modelling and learn how to construct discounted cash flow models for senior debt and mezzanine finance for investment and lending decisions. Sign up here: https://cambridgerefinance.com/modelling-courses/debt-course/