Top 5 Reasons to Invest in Mezzanine Debt

Guest blog post from Tom McCahill, Head of Mezzanine Debt for Everwest Real Estate Partners

Mezzanine debt borrows its name from the architecture world. In buildings, a mezzanine is an intermediary story between two main levels. It is a good analogy to mezzanine financing where the term is used to describe capital that has a seniority placement between equity and senior debt financing.

From a real estate developer's or operator's perspective mezzanine financing makes sense in certain circumstances. For instance, the financial institution providing the senior loan may only be willing to provide a certain amount of capital and the developer or operator needs more capital. This may be due to various underwriting limitations (a high loan-to-value requirement, etc.). The developer has two options, they can provide the balance in equity or provide the balance with a combination of equity and mezzanine debt. The advantage in using mezzanine debt is that sometimes it is difficult to obtain the entire balance of capital needed for a project from equity. Mezzanine investors receive a higher position in the capital table (that is if the tenants move out or fail to pay rent the mezzanine investors get their money before the equity investors).

When investors are considering the pros and cons of making an equity investment or a mezzanine investment they should look at several factors:

1) Mezzanine debt investors are looking for current yields that are higher than are typically available on an equity investment. Equity returns are a function of available cash flow after the payment of all debt obligations, including the mezzanine debt. Therefore, current yields (or cash-on-cash yields) will be higher for mezzanine than for equity, although overall returns may be slightly lower for mezzanine.

2) Mezzanine debt investors are looking for a cash return that is less variable than equity. Equity returns are attached to building occupancy and rental rates (higher occupancy & rental rates equals higher returns, lower occupancy & rental rates equal lower returns) and equity appreciation returns are subject to supply and demand of the market at the time of sale. Alternatively, mezzanine returns are contractual obligations and get paid in full, generally as a fixed amount, before any cash is paid out to equity investors.

3) Mezzanine debt investors are seeking an investment that is lower risk than equity. Because mezzanine investors always get paid before equity investors they are exposed to less risk and have some protection against the ups and downs of market cycles and the occupancy & rental rates of the market and the individual property.

4) Mezzanine debt investors will not participate in the upside profits. The equity investors have the opportunity to participate in the profits from increased rents or higher occupancy and the capital appreciation from the proceeds of a sale. Since mezzanine debt investors receive a contractually agreed upon cash return they do not participate in the upside profits like equity investors.

5) Some mezzanine financial instruments operate as hybrids of debt and equity. In some deals, mezzanine financing is offered as a hybrid with some form of downside protection or seniority but also some opportunity to participate in the upside, generally with a cap or series of financial hurdles.

Considering an investment in mezzanine debt versus equity is ultimately about an investor deciding where they want to be on the risk/return continuum for a specific deal. Equity offers a higher risk and higher return, mezzanine debt offers a lower risk and lower return.

As investors are building out a portfolio of syndicated real estate the same rules of portfolio management apply as they would to a portfolio of stocks and bonds. Portfolio theory dictates that a portfolio should be diversified and contain a basket of assets where some generate income, some generate capital appreciation, and the assets are as uncorrelated as possible '“ that is, when some of the assets go down in value other assets will increase in value or stay the same in value. That minimizes the likelihood of the entire portfolio realizing a loss all at once. Different investors have different goals and different portfolios have different goals, equity, debt, and hybrids all serve different purposes in a portfolio.

Mezzanine debt is a fixed income alternative investment with high yields. Investors that have seen a run-up in the value of their stock portfolio may consider rebalancing a portion of their portfolio into real estate income investments like mezzanine debt. Crowd Street provides individual investors with access to investment-grade mezzanine debt investments, like EverWest Real Estate Partners' 30 Knightsbridge, where investors can partner with highly experienced sponsors to get access to real estate assets.

This guest blog post is from Tom McCahill, who serves as Head of Mezzanine Debt for Everwest Real Estate Partners. Previously, Tom was Managing Director of Pearlmark Real Estate Partners, L.L.C. (formerly Transwestern Realty Finance Partners). He was responsible for all investment strategy, origination and portfolio management activities for Pearlmark Mezzanine Realty Partners III, L.L.C. a $427 million investment fund targeting subordinate debt. Tom has been a pioneer in the subordinate debt sector; having sponsored four funds with over $1 billion dollars in capitalization and has invested over $2 billion in mezzanine, B Notes and preferred equity since 1998. Tom has served as Adjunct Professor of Real Estate at the University of Colorado and is a member of the Urban Land Institute (ULI) and the Pension Real Estate Association (PREA).