- Senior debt is money provided by a lender in return for a first position mortgage on the collateral property. It is considered “senior” because the lender is first in line to be repaid at all times.
- Senior debt is one of the four major components of the “capital stack.” From a risk/return perspective, it is generally considered to be the least risky. As a result, it also offers the lowest return.
- Basic features of senior debt include the first position mortgage, the ability to initiate the foreclosure process, and the ability to require the borrower to meet certain covenants.
- Senior debt is different from subordinated debt in the sense that the holder is in first position for repayment. Any holder of debt that is “subordinate” to the senior lender is behind them in line.
- Senior debt is different from unsecured debt in the sense that it is secured by tangible collateral. By definition, unsecured debt does not have any collateral.
- From an investment standpoint, senior debt can be a way to earn passive income with relatively low risk. But, investors should always complete their own due diligence to ensure that the risk characteristics of the specific deal are a fit with their own investment objectives.
What is Senior Debt in Commercial Real Estate?
Nearly all commercial real estate (CRE) asset purchases are financed with some amount of debt. But, there are different flavors of debt and the types (and amounts) used can have a significant impact on the risk/return profile of a commercial real estate investment opportunity.
In this article, a specific type of debt known as “senior debt” is discussed.
What is Senior Debt?
In a commercial real estate investing context, the easiest way to think about senior debt is as the loan balance that is owned to a bank or real estate lender. At the time of purchase, the debt is provided by the lender and it is paid back by the borrower over time with income generated by commercial tenant lease payments.
Senior Debt and the Capital Stack
The “Capital Stack” is the term used to describe the collection of capital used to finance a real estate investment. The exact composition can vary from deal to deal, but it can consist of up to four components:
Each component has unique features, repayment order, and a risk/return profile.
Basic Features of Senior Debt
There are several features of senior debt that set it apart from the other components of the Capital Stack:
- Repayment Priority: “Senior” means that the debt holder has a first position claim on the cash flow and profits produced by the collateral property. Practically, this means that they are first in line for whatever money is left over after a property’s operating expenses have been paid.
- Security: Typically, senior debt is secured by a first position mortgage/lien on the collateral property. In the event of a bankruptcy or foreclosure, this security is what entitles the senior debt holder to be first in line for repayment.
- Foreclosure: In the event of default, the senior debt holder has the ability to initiate the foreclosure process to reclaim title to the property and sell it to be repaid.
- Risk/Return: Because the senior debt holder has a first position claim on cash flow and profits, their investment is considered relatively low risk. As a result, it typically offers a relatively low return. The return is represented by the interest rate charged by the lender, usually somewhere in the 4% – 8% range.
- Covenants: Often, senior debt comes with “covenants” which are affirmative promises made by the borrower to the lender. If one of the covenants is broken, it constitutes a technical default on the loan.
Senior debt is offered by a variety of banks and lenders and its wide availability and generally favorable repayment terms is one of the major benefits of a commercial real estate investment opportunity. But, this isn’t the only type of debt that can be found in a commercial property purchase transaction.
Senior Debt vs. Subordinated Debt
The key difference between senior debt and subordinated debt is the order of repayment. Any debt that is “subordinate” to senior debt means that their claim comes behind the senior debt holder’s.
In commercial real estate, a classic example of subordinated debt is a type of debt known as “mezzanine debt.” This is another type of loan that is meant to fill the gap between the senior debt and equity. Depending on the specific capital structure of the transaction, mezzanine debt could be secured by one of the following:
- Second Deed of Trust: This type of collateral allows the mezzanine lender to also place a lien on the property and initiate foreclosure proceedings in the event of a default. As such, this is the first choice of collateral, but it is also the least common. Senior lenders typically won’t allow it.
- Assignment of Partnership Interest: This is the most common form of security in a mezzanine loan. In the event of default, it allows the mezzanine lender to take over as the equity partner and assume their responsibilities.
- “Soft” Second Mortgage: With this collateral, the mezzanine lender requires an assignment of cash flow and sale proceeds from the property. But, this is not a recorded instrument, which is why it is referred to as a “soft” second mortgage.
By definition, the subordinated debt holder’s position carries more risk. As such, they demand a higher return which is usually in the 10% – 15% annually range.
Senior Debt vs Unsecured Debt
The key difference between senior debt and unsecured debt is collateral. Senior debt is secured by a first position mortgage on the collateral property. By definition, unsecured debt does not have any tangible collateral. Instead, unsecured debt holders typically receive a general claim against the company’s assets. However, in a commercial real estate transaction, the company only has one major asset, the property.
Because unsecured debt is not secured by any tangible collateral, it is the riskiest type of debt. As such, it also comes with the highest interest rate.
Senior Debt Covenants
As described above, one of the features often found with senior debt is a set of “covenants.” Again, covenants are promises made by the borrower to the lender. However, it is the lender that requires the promises. Covenants are unique to each individual deal and formulated during the underwriting phase, but some of the most common ones include:
- Loan to Value (LTV): Some lenders may require a borrower to maintain a certain LTV ratio at all times in the loan transaction. It may be tested regularly with third-party appraisals.
- Debt Service: Frequently, lenders require the borrower and the property to meet a certain debt service coverage ratio (Net Operating Income / Debt Service) at all times. It is also tested regularly with property financial statements.
- Liquidity: Lenders may require the borrower or the property to maintain a certain amount of cash at all times. This is also tested regularly by examining financial statements.
- Reporting: Lenders frequently require the borrower to provide them with financial statements on a regular basis.
The purpose of senior debt covenants is to further de-risk the lender’s position. If a covenant is broken, it may constitute a “technical” default on the loan, which can set off a string of adverse events for the borrower. For example, a technical default could accelerate interest due or cause the interest rate to rise to the “default rate” which is usually very high.
Is Senior Debt a Safe Investment?
Relative to investing in other components of the capital stack, yes Senior Debt can be a safe investment. But, it depends on the specific structure of the real estate deal. For example, a transaction where a senior loan makes up 50% – 60% of the property purchase price has a completely different risk profile than a transaction where it makes up 95% of the purchase price.
For potential debt investors, it can be tempting to think of senior debt as a very safe investment because it sits at the top of the capital stack. This may be true, but it is critically important to perform a significant amount of due diligence on the borrower, the property, the market, and the property tenants. If all of these look good, debt investments can be an effective way to benefit from a regular stream of income via the monthly principal and interest payments.
However, it is also important to remember that a debt investment has a relatively limited return potential. Investors earn interest on their money, but that is it. There is no profit participation upon sale. For this reason, senior debt returns tend to be fairly consistent in the 4% – 8% range.
Senior Debt Example
To understand exactly how senior real estate debt works, a simple example is helpful.
Suppose that an investor was going to purchase a property for $20,000,000. As part of the transaction, they have arranged an interest only senior loan for $12,000,000. The remainder of the purchase price is raised as an equity investment.
Now suppose the borrower defaults on the loan and the senior lender forecloses on it. This is where the “senior” part of the debt becomes very important. In a forced sale, the “senior” lender is first in line to receive the sale proceeds. So, the foreclosure sale price would have to fall to less than $12,000,000 for the senior lender to be in jeopardy of not receiving all of their money back. This is a big fall and it demonstrates why the senior position is relatively safe.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
IF you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
Learn & Invest
The Ultimate Guide To Investing In Private CRE
The Comprehensive A-Z Guide Every Accredited Investor Should Read Before Investing in Private CRE Deals. Instant eBook Download. Updated for Q1 2021.Download Ebook
The Art of Commercial Real Estate
Learn from private equity fund managers how to become a top CRE operator and investor. True success requires an "it" factor. Find out if you have "it".DOWNLOAD NOW