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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2006

Behind Capital Markets

Comprehending highly structured capital markets can help you match clients with the appropriate capital

In the not-too-distant past, real estate finance was synonymous with banking. If developers needed financing for a real estate project, they approached the local bank for a development or acquisition loan. They filled in the gap with equity from their own balance sheet and from the balance sheets of friends and family.

Today, the capital markets have made great inroads into the real estate industry. There are fewer local banks, and there are many more financing alternatives for real estate investors and developers. Understanding how they work is crucial to success.

Debt and equity

Before 1984, the real estate capital markets were largely a private industry. Equity was mostly held in private companies with no reporting requirements. Leverage primarily came from banks or life insurance companies, which were typically private or mutual companies with minimal public-reporting requirements. These minimal requirements resulted in a lack of transparency.

During this time, continued overbuilding led into recession. This exacerbated the general economic decline, which caused major peaks and valleys in real estate investment returns. These boom and bust cycles were a primary reason why institutional capital “red lined” real estate investment.

The commercial-mortgage-backed-securities (CMBS) market evolved mostly as a result of the savings-and-loans crisis in the late 1980s. It began to inject public market regulation, scrutiny and discipline into real estate debt markets. Similar to the debt market, real estate equity was essentially a private market before 1990.

From the late 1990s through today, the market has continued to mature. The debt and equity markets have stratified into multiple risk/return tranches to mirror lenders and investors risk/return profiles.

Today, according to the Mortgage Bankers Association, CMBS represent more than 20 percent of the $2.7 trillion U.S. commercial mortgage debt market. The public market for real estate equity, primarily via real estate investment trusts (REITs), has grown from less than $2 billion in 1990 to more than $300 billion in equity in 2005, according to the National Association of Real Estate Investment Trusts.


Lenders have different yield requirements based on the composition of their funds and the amount of risk they are willing to acquire. Some lenders only finance stabilized properties in one of the four main “food groups” — multifamily, retail, office and industrial. Others rarely finance these properties because they need to achieve higher yields. Some capital providers target mezzanine loans to 80 percent of capital, others to 85 percent or 90 percent.

Each has a different risk/return threshold. Borrowers should expect the pricing to increase as perceived risk increases. Preferred-equity providers usually play in the range of more than 85 percent or 90 percent and cap out at 95 percent to 98 percent of capital. Their yield requirement typically will be more than that of the aforementioned mezzanine providers.

Even senior debt is seeing more tranches, with low-risk, low-pricing lenders taking only the investment-grade components of senior loans and letting other players buy the noninvestment-grade tranches.

This can be simplified by understanding that each capital provider is playing in the risk-adjusted space of its choice. It would be inefficient for a traditional mezzanine lender to try to finance a senior loan because the risk/return profile would not be in line with the capital it had to deploy.


The graph outlining capital market segmentation can benefit both lenders and borrowers. It can show how borrowers how to fill their required capital stack with the appropriate risk-adjusted tranche or tranches of capital. It can help lenders and investors play in the capital structure where they are most comfortable. 


If borrowers need financing to get 88 percent of their acquisition cost, they can obtain that financing from the optimal mix of lenders and capital providers who can price-adjust their capital so that the borrowers realize a competitive advantage. Borrowers would be overpaying for 95-percent capital if all they needed was capital to get to 88-percent leverage.

The trick is to match the project and leverage risk with the appropriate capital-provider for the appropriate tranche of capital. Many senior and mezzanine lenders turn to tranches after closing by selling various segments of the loans to third-party capital providers, much like a more conventional participation loan.

By understanding what is available in the market and the dynamics of structured finance, brokers and borrowers can more readily navigate the capital waters. Brokers can take advantage of the maturity and segmentation of the financial markets by identifying the appropriate lenders for their clients’ projects. Borrowers will likely find it beneficial to use a broker experienced in structured finance who can find capital-providers that offer financing products for different parts of the capital stack (senior debt, mezzanine and preferred equity).

Ultimately, brokers can decrease their clients’ financing costs by efficiently matching the risk of a transaction with the appropriate capital.


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