In the commercial real estate context, capital can come from various sources of financing that are used to finance the purchase and development of a real estate project. These sources are either debt or equity and can be broken down into four main categories which are common equity, preferred equity, mezzanine debt, and senior debt. If a real estate investment doesn’t achieve its objectives, there is an order for investors to be repaid and some risks related according to the nature of the instrument investment.
The order of priority for repayment is as following:
1. Senior debt
Senior debt is the first to be repaid during bankruptcy, all the other debts are subordinated. It offers the lowest risk but also the lowest return and interests. Investors receive dividends which are a fixed rate of return. Senior debt is the cheapest form of investment and is collateralized by tangible assets. If the borrower cannot pay, the lender can take possession of the property. The borrower must provide a form of caution to the lenders which usually comes from banks. The holding period of a senior debt is usually 6-24 months.
Mezzanine debt, or junior debt, is a highly subordinated debt between senior debt and equity. The mezzanine debt investor will be repaid only after full repayment of all range of senior debts. This level of risk is usually compensated with share warrants that improve the profitability of the credit. If the developer remains unable to pay, the lender can easily take control of the asset. The duration of such debts is usually 2-4 years.
3. Preferred equity
Preferred equity is a very flexible part of the capital stack. It is more expensive but has priority of repayment over common equity. Usually, it takes a similar form as mezzanine debt with fixed coupon and maturity term (2-4 years) but can also vary into different forms closer to equity shares. It is not secured by a property but rather by an interest in the entity investing in.
Preferred equity and mezzanine debt have the same function in the capital stack. Both are considered as forms of “bridge financing”. These are financing methods of short-term capital requirements to fill the gap between debt and equity in the overall capitalization of the project. The main difference with the mezzanine debt is the legal rights which apply in case of bankruptcy.
4. Common equity
In common equity investments, investors are shareholders. They receive a percentage interest in the form of a share of the income the investment generates and own a portion of the company. If the project loses money, investors loses their money as well. The stock market is very volatile with rapid changes in share values. Investment by equity has the highest risk of loss, but also the highest potential return. The holding period is usually much longer than with debt investments (5-10 years).
These four investment instruments have their pros and cons. Therefore, investors should weight carefully each option in order to fully understand the risk involved and take the best decision. At BrickVest, we only offer investment deals through equity, with a current annual expected return ranged between 7,2% and 25%.
Comparison table of investment instruments