The Market for Mezzanine and Supplemental Finance in Commercial

Optimal Capital Structure and The Market for Outside Finance in Commercial Real Estate

Timothy J. Riddiough University of Wisconsin-Madison, Graduate School of Business

975 University Avenue, Madison, WI 53706 (608) 262-3531 / [email protected]

August 2004

Abstract

When asked about optimal capital structure, the typical response from a commercial real estate investor is “go for it—use as much debt as possible.” Although often the correct answer, when asked why, the response is less compelling, often that “debt is cheaper than equity, so use debt.” This answer, while not necessarily incorrect, is not terribly informative. This paper seeks to articulate the economics underlying the market for outside finance in commercial real estate, therefore answer the optimal capital structure question. I establish why a capital structure of inside owner equity and outside senior mortgage debt has worked well historically in terms of producing a low weighted average cost of capital for property owners. The effects of tight constraints on the supply of senior mortgage debt in the context of robust demand for outside finance are then examined. Analysis demonstrates how a gap in the traditional market for outside finance can come to exist and how supplemental financiers can enter to plug the gap. A range of possible supplemental security designs is discussed, including subordinated (mezzanine) debt, convertible debt, and outside equity.

Optimal Capital Structure and The Market for Outside Finance in Commercial Real Estate

Introduction

Economic wealth is largely created and destroyed in commercial real estate through dealmaking

and development projects. This explains the industry’s obsession with economic fundamentals,

efficient execution of the development process, and the “art of the deal.” Outside finance is the

lifeblood of this capital-intensive business, however, since, given the limited liquidity of most

industry participants, access to capital is critical to harvesting investment opportunities.

Determining the appropriate mix of inside and outside finance, otherwise known as the optimal

capital structure decision, has also created and destroyed much wealth over the years. Too much

inside equity means there is not enough liquidity left over to fund new investment opportunities.

Too much outside finance, or the wrong kind, can result in skyrocketing capital costs and

deadweight losses due to the increased likelihood of financial distress or because of monitoring

and control issues.

When asked about the optimal capital structure, most private commercial real estate investors

respond, “use as much (non-recourse) debt as possible.” Although this is often the correct

answer, when asked why the response is less compelling, often that “debt is cheaper than equity,

so use debt.” This answer, while not necessarily incorrect, is not terribly informative, as debt is

always cheaper than equity. What matters is whether using as much mortgage debt as possible

results in the lowest weighted average cost of capital.

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In order to consistently create value through financing decisions, one must not only know how to

obtain outside finance, but also why it does or doesn’t make sense. In this article I explain the

economics underlying the market for outside finance in commercial real estate, and thus answer

the optimal capital structure question.

The basic story is as follows. Limited wealth of the private investor creates demand for outside

finance. Mortgage debt is typically the optimal form of outside finance, as it economizes on

transaction costs and provides proper incentives for the property owner. An inside equity/outside

mortgage financing split therefore maximizes comparative advantage: the property owner is

allowed to do what he or she does best—own and operate the commercial real estate asset with

few distorting incentives—and the mortgage lender does what it does best—screen borrowers for

credit and related risks, write efficient contracts for outside financing, and allocate capital as a

financial intermediary from those who have it to those who need it.

Effects of tight constraints on the supply of senior mortgage debt are subsequently analyzed in

the context of a robust demand for outside finance. Restricted supply and robust demand will

create a gap in the market for traditional outside finance in commercial real estate, providing

opportunities to non-traditional capital providers. A range of possible supplemental security

designs are discussed, including subordinated (mezzanine) debt, convertible debt, and outside

equity.

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Economic Foundations and Framework for Analysis

Traditional Financing of Commercial Real Estate

Commercial real estate is a capital-intensive business. Most industries that require vast amounts

of capital for investment (such as the automobile and utility industries) long ago became publicly

held corporations. Yet a large percentage of commercial real estate has been, and continues to be,

privately owned.1

The conventional wisdom is that the location-specific nature of the asset creates barriers for

large-scale ownership. Evidence from the REIT sector confirms the conventional wisdom: Scale

economies are difficult to realize with commercial real estate, and certain operating

diseconomies of scale may in fact obtain.

Private ownership of commercial real estate has implications for financing. Most important is

that the capital required for investment dwarfs the personal wealth of most property owners. This

implies that outside finance is typically required to fund investment. At the same time, the

outside financing market has long recognized that some owner equity is required so that an

owner has a sufficiently large stake in the investment. This happens to minimize value-depleting

behavior, and therefore maintain owner-manager incentives to: i) make good initial investments,

ii) efficiently operate the asset, and iii) reinvest in the property in good times and in bad times.

1 The ownership structure of commercial real estate has changed some in recent years, as REITs and institutional investors have gained larger ownership shares of the market. This is especially true of larger and higher quality stabilized assets found in prime locations in first-tier cities. A vast amount of commercial real estate is still privately owned, however, equaling about 80 percent of the investable universe.

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Because private commercial real estate investors are wealth-constrained, they will seek

significant outside capital to fund investment. What is the optimal capital structure in this case?

Typically a single source of mortgage debt has been of sufficient size and cheap enough to

bridge the financing gap. But why a single source of mortgage debt, and why not other financial

configurations?2

Commercial real estate is a durable asset that generates cash flow for many years into the future.

And because fixed-term lease contracting is standard practice in the industry, commercial real

estate produces fairly predictable near-term cash flows. Predictable cash flows give mortgage

lenders confidence that the debt will be serviced. Furthermore, long-term durability increases the

likelihood that asset value will be sufficient to offset the remaining loan balance at maturity, and,

if not, that the asset will retain significant resale value to mitigate loan default losses.

To economize on contracting, monitoring, and related transaction costs, mortgage debt does not

vest day-to-day operating control with the lender. The lack of day-to-day control can, however,

create principal-agent problems. Principal-agent problems may be addressed in two basic ways.3

First, as I have noted above, sufficient equity contribution by the property owner is generally

required in order to create a stake in the asset. An equity stake mitigates underinvestment

2 The statement that only a single source of outside capital has traditionally been required is, of course, a simplistic description of the market. Tax law and regulatory regimes, highly wealth-constrained property owners, and settings in which investment has a public purpose often result in more complex financing schemes. In many standard situations, however, a single source of mortgage debt has historically been sufficient to fund investment. 3 Principal-agent problems describe potential conflicts of interest problems that exist between two or more transacting parties with differing objective functions. Moral hazard is one prominent class of principal-agent problems. Once a relationship between a principal and an agent has been established, incentives of one party conflict with objectives of the other party (e.g., debt providers want the property owner to properly maintain the asset, but the property owner may wish to skimp on maintenance).

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problems and other distortions that can occur when outside finance is provided.4 Mortgage

lenders have generally looked for equity stakes in the range of 15 to 25 percent of asset value,

which has been feasible for many property owners.

Second, contractual provisions are often used to head off principal-agent problems. Maintenance

and lock-box requirements are examples of such provisions. These provisions result in a more

complete mortgage contract and have generally worked well to align the incentives of the debt-

and equityholders.

Why is mortgage debt preferred over other alternative financing sources—in particular, outside

equity? There are several reasons. First, outside equity capital providers will be concerned about

profit-sharing rules and control issues that are not as important to debt providers. This creates

monitoring and legal costs for both the inside and outside equityholders. Risk concerns are

intensified because the property owner (as inside equity contributor) generally has better

information about the true risks and returns of investment. Transaction costs and supplemental

risks will be priced into the cost of capital, and are often prohibitively high.

Mortgage debt economizes on transaction costs and provides proper incentives for the property

owner. The property owner receives all the upside from investment when things go well (subject

to the fixed debt repayment amount), which creates incentives to maximize asset value. Control

is exerted by the mortgage lender only in the (unlikely) event of weak property performance or

4 Underinvestment is the tendency of property owners to skimp on maintenance and to pass up good reinvestment opportunities when they believe that the benefits from such investment will accrue disproportionately to the outside financiers. A related distortion is risk-shifting, where the asset owner undertakes high-risk investments in an attempt to reap upside benefits if things go well but to shift the downside to debtholders if things go badly.

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borrower default. An inside equity/outside mortgage financing split therefore maximizes

comparative advantage: the property owner is allowed to do what he or she does best (own and

operate the commercial real estate asset with few distorting incentives), and the mortgage lender

does what it does best (screen borrowers for credit and related risks, write efficient contracts for

outside financing, and allocate capital as a financial intermediary from those who have it to those

who need it).

A Short Detour: Life in the M-M Lane

When financial markets function well in the sense of being competitive with low transaction

costs and an even distribution of information, they will be efficient at sorting out risk and return

from investment. In theory, when there are absolutely no market frictions or inefficiencies, it

does not matter how the owner finances investment. Any combination of debt, equity, or hybrid

finance will result in the same weighted average cost of capital (WACC) for the asset owner,

where the WACC depends only on fundamental asset risk. This is the famous Modigliani-Miller

(M-M), or value preservation, theorem.5

In an M-M world, there is no preferential role for leverage-increasing debt. That is, the rule-of-

thumb often heard in commercial real estate—that debt is cheaper than equity; therefore use as

much debt as possible—does not apply in an efficient market setting. Higher debt levels require

5 A frictionless capital market implies an inability to conduct riskless arbitrage, which in turn establishes a unique price for similar-risk assets. Another way to express the M-M result is to say that what happens on the liability side of the balance sheet in no way affects the asset side of the balance sheet. Real estate appraisers implicitly assume that the M-M theorem holds when they estimate property values independently of the nature of the financing.

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higher returns to equity, which cancels out the preference for less expensive debt in the capital

structure, to result in a constant weighted average cost of capital.6

This effect is illustrated in Figure 1 in terms of supply and demand for outside capital to finance

commercial real estate. The x-axis shows the quantity of outside capital that is demanded by the

property owner and that is supplied by the outside financier. The y-axis displays the risk-

adjusted return that is willingly paid by the property owner and that is required by the marginal

supplier of outside capital.

In our context, risk-adjusted return means the return on capital after subtracting expected credit

losses and other “standard” compensated risks. I adopt this characterization to avoid

complicating the analysis with risk adjustments that are present in efficient financial markets,

and therefore to isolate real economic costs and benefits associated with outside finance. This

adjustment also allows for a unified analysis of all outside financial claims, such as pure debt and

pure equity positions.7,8

6 Some argue that, due to risk-loving preferences of commercial real estate property owners, higher expected returns that accompany the use of debt more than offset the higher levels of equity risk. I personally do not believe this argument; rather, my contention is that property owners express a preference for debt because it results in the lowest weighted average cost of capital. Outside equity usually increases the WACC relative to the use of outside mortgage debt, so there is a preference for debt. 7 By standard risks, I mean compensation for full-information credit risk and risk-aversion. After compensating for these risks in perfectly functioning markets, a riskless return is required. Information and other “non-standard” risks represent market frictions to be isolated and analyzed. If expected credit losses were added back to obtain the actual rate offered as a function of credit risk, debt suppliers would require a strictly increasing return as a function of the quantity of outside finance. 8 The required return on a pure debt position starts with the risk-free rate of interest and is then adjusted upward to compensate for credit risk. The required return on a pure equity position starts at the required return on the asset and is then adjusted upward as debt levels increase. By subtracting credit risk and the effects of risk-aversion, different types of claims are fully comparable and can therefore be represented generically.

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In perfect markets for financial (as well as real) capital, the supply (S) and demand (D) curves

exactly coincide. The risk-adjusted return in this case is the risk-free rate of interest, rf, which is

constant regardless of the quantity of outside finance demanded and supplied. This means that

outside financiers are willing to supply as much capital as is needed at a constant risk-adjusted

return to property owners for investment purposes.

Figure 1

Market Equilibrium for Outside Finance in Perfect Capital Markets

Risk-Adjusted Return (r)

rf S & D

0 Quantity of Outside Finance (Q)

Because property owners are not capital-constrained in this idealized world, they always have the

option to supply 100 percent inside equity capital and are willing to use outside finance only if

the price is right. If the risk-adjusted cost of outside finance is above rf, no outside finance will

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be demanded. The property owner cannot afford to pay more than rf because the opportunity cost

of owning the asset is such that its required return exactly equals the cost of inside equity capital.

If the price of outside finance is below rf, the property owner will demand as much outside

finance as it can get. A below-market price would be unsustainable for outside capital suppliers,

however, since they would not make a fair return on their investment. This pushes the supply

curve up to precisely coincide with the demand curve to generate a risk-adjusted return of rf.

Back to the Real World of Market Imperfections and Financing Preferences

The idealized frictionless M-M world does not exist of course, and is described conceptual

benchmarking purposes. I have, in fact, already recognized several frictions in the market for

outside commercial real estate capital. Most important, property owners are equity capital-

constrained. This means that the demand curve for outside capital will be downward sloping and

particularly steep (inelastic) at low quantity levels.

The property owner is willing and able to pay relatively high costs for outside capital because the

market for real property is also imperfect, in the sense that real investment profit opportunities

allow property owners to pay a premium for outside finance. At higher levels of outside finance

the demand curve will begin to flatten out (become more elastic), since the property owner is

willing to substitute inside equity if outside capital costs are too high.

Transaction costs and conflicts between the property owner and outside financiers generally

increase as the amount of outside finance increases. This will cause the capital cost supply curve

to display a positive slope, and increase substantially once a sufficiently high outside finance-to-

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property value ratio is surpassed. Additional concerns over adverse selection and other

information-based risks that cannot be resolved through the underwriting and contracting

processes will shift the supply curve upward and perhaps cause the slope to increase as a

function of quantity.9 Another traditional constraint on supply is regulation. Bank and insurance

regulators, who focus specifically on the credit quality of the loan portfolio, generally frown on

high loan-to-value ratio loans. This causes the supply curve to truncate or to drastically increase

in slope at higher quantity levels.

These imperfections combine to result in a market for outside finance that approximates the

equilibrium displayed in Figure 2. The intersection of the supply and demand curves determines

the amount of outside finance that is utilized (Q*) as well as the rate paid on the capital (r*). The

adjusted rate of return on outside finance exceeds rf due to marketplace frictions that constrain

supply. The property owner is willing and able to pay this premium because of wealth constraints

and because the real investment opportunity is sufficiently profitable. The area below the

demand curve and above r*, going from a quantity of 0 to Q*, measures the residual economic

value of investment (the “consumer’s surplus”) after accounting for the cost of outside capital.

Figure 2 is meant to illustrate the traditional market for outside capital in commercial real estate.

In a traditional market the equilibrium quantity of outside finance at the time of issuance: i)

represents approximately 70-85 percent of asset value; ii) is supplied by a single source as

mortgage debt; and iii) does not require a high premium on capital above the “frictionless” risk-

9 Adverse selection is concern that property owners will use what they know to the detriment of the outside financier. For example, lenders may be concerned when a loan applicant offers to share some investment upside in return for a lower loan rate of interest. Because the property owner will want to keep all of the upside on projects with good investment potential, but will offer to share when the upside is less likely, an offer to share upside is properly interpreted as a signal of a questionable investment opportunity.

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adjusted rate. There is no financing gap in this setting, as the property owner is able to fund

investment through the traditional suppliers of outside finance at relatively low cost.

Figure 2

Market Equilibrium for Outside Finance: Traditional Market

Risk-Adjusted Return (r)

S

r*

D rf

0 Q* Quantity of Outside Finance (Q)

Analysis of Supplemental Outside Financial

A Constrained Market For Traditional Outside Finance

Market forces can change to change the equilibrium relation between property owners and

traditional outside capital providers. A particularly interesting and relevant change is when

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lending conditions tighten, which can cause financing gaps to emerge. This in turn can provide

market opportunities for non-traditional suppliers of outside finance.

A constrained lending environment is often the result of strict regulatory oversight of banks and

insurance companies. Constrained lending can also result when banks and insurance companies

place a high value on liquidity and transparency. Because there are first-order relations between

liquidity, transparency and asset quality, traditional mortgage sources will prefer to make

“investment-grade” loans on commercial real estate (loans with lower loan-to-value ratios

collateralized by larger, newer, stabilized assets in the better locations in larger markets).

Supply is sometimes restricted when the demand for outside finance by private market investors

is robust. One possible cause of increased capital demand is lower capitalization rates. Lower

capitalization rates translate into higher relative transaction prices, implying tighter wealth

constraints for many property owners who must ration scarce equity capital among a number of

investment opportunities.10 Moreover, lower capitalization rates imply lower relative cash flow

returns from investment. This limits cash flow availability for further investment as well as

makes it more difficult for a property owner to meet debt coverage ratio constraints on mortgage

debt financing.

When constrained supply and robust demand are considered together, a new equilibrium for

traditional outside finance emerges. Representative market outcomes are displayed in Figures 3

and 4. In Figure 3, supply has shifted in from S to S′ in response to new constraints on traditional

10 For seasoned investors, lower cap rates may temporarily result in looser wealth constraints as asset sales and increased equity levels in existing assets create significant capital gains.

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outside finance. At the same time, changes have caused the demand curve to shift from D to D′.

These shifts have increased the real cost of traditional outside finance, where the risk-adjusted

return moves from r* to r′*. Quantity has simultaneously declined from Q* to Q′*.

Figure 3

Market Equilibrium for Traditional Outside Finance: Constrained Market

Risk-Adjusted Return (r)

S′ S

r′*

r* D′ rf D

0 Q′* Q* Quantity of Outside Finance (Q)

In response to the change, new capital suppliers have the opportunity to enter the market to offer

funding at lower costs and greater total quantities. There are two basic ways for entry to occur.

One way is for new capital suppliers to completely substitute for traditional capital suppliers by

offering a single larger source of outside finance at a lower cost. The other way is for new

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suppliers to complement traditional capital sources by offering supplemental outside capital that

falls between senior mortgage debt and inside equity in the asset’s liability structure.

I will analyze the case in which traditional mortgage lenders continue to be low-cost suppliers at

low to moderate quantities. Consequently, the market opportunity is for complementary, or

supplemental, forms of outside finance. Supplemental finance typically represents anywhere

from 5 to 25 percent of the middle portion of the liability structure—where a senior mortgage

debt position is generally 60 to 65 percent and inside equity is 10 to 30 percent of the liability

structure.

Without a new secondary source of outside finance, market equilibrium is as described in Figure

3 with a cost of capital, r′*, and quantity, Q′*. Figure 4 depicts the market opportunity for

supplemental outside finance that asssumes entry by a low-cost supplier of supplemental capital

with supply curve S′′. The quantity at which the secondary source of capital becomes available is

Q1*. For quantities greater than Q1

* the supplemental financier can offer capital elastically and

therefore at a lower cost than traditional outside capital providers. In this market equilibrium, the

total quantity of outside capital issued is QT* at a weighted cost of rT

*.

The primary source of outside finance (e.g., senior mortgage debt) is now offered at a rate of r1*

and quantity Q1*, where the equilibrium rate and quantity are lower than in the absence of a

market for supplemental finance. The quantity of supplemental finance is QS* = QT

* − Q1*. The

property owner is able to access more capital in this market (an increment of QT* − Q′*) at a

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lower average cost (rT* rather than at r′*). This is a Pareto efficient outcome, meaning that the

introduction of a market for supplemental capital is a socially desirable outcome.

Figure 4

Market Equilibrium for Outside Finance: Constrained Market with Supplemental Capital

Risk-Adjusted Return (r)

S′ S′′

r′*

rT*

r1* D′

r f

0 Q1* Q′* QT

* Quantity of Outside Finance (Q)

The risk-adjusted cost of supplemental finance exceeds rT*, since the cost of the senior debt is r1

*

< rT*. Because rT

* is the weighted average cost of outside finance across two capital sources, the

risk-adjusted cost of supplemental finance to the property owner, rS*, is *

S

*1

*1

*S

*T

*T*

S QQr

QQrr −= . For

example, assuming that Q1* = 60, QT

* = 90, r1* = .05, and rT

* = .06, then QS* = 30 and rS

* = .08.

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To obtain the observed market rate of interest for both the first and the supplemental source of

outside finance, one has to add back adjustments for full information credit risk and risk

aversion. These adjustments might, for example, be 1.0% for a 60 percent loan-to-value senior

mortgage and 5.0% for 30 percent loan-to-value supplemental finance that results in a total

outside finance-to-value ratio of 90 percent. If the rate of interest is 4.0% on a comparable-

maturity Treasury bond, then (using numbers from the previous example) the senior debt

requires a 200 basis point premium (100 + 100 bps) over Treasury security rates, and the

supplemental position requires a 900 basis point premium (400 + 500 bps) over Treasuries.

Design of Supplemental Financial Claims

Supplemental finance can plausibly take a number of different security designs. Extreme cases

are subordinated (mezzanine) debt and outside equity. Actual security design will depend on

which is most efficient at addressing borrower needs, financier information concerns, control

issues, and supplier capital costs.

Alternative security designs can be characterized using payoff diagrams. As a base case, Figure 5

shows payoffs resulting from a traditional financing structure of outside mortgage debt and

inside equity. Assuming a debt payoff amount of D1, the property owner receives all of the

upside when the asset value, V, exceeds D1. In this case, the mortgage lender receives the

contracted payoff amount, D1. However, if asset value, V, turns out to be less than D1, the

property owner defaults by putting the asset to the lender and walking away with a zero payoff

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(assuming non-recourse debt). The lender repossesses the asset in lieu of receiving the contracted

payoff amount, and sells it into the market at its current value, V.

Figure 5

Payoff Diagrams to Inside Equity, Senior Debt, and Asset Value

Payoff to Claimholder Asset Value Inside Equity D1 Senior Debt 45° 0 D1 Asset Value, V

The levered property owner’s payoff function resembles a classic call option (a convex payoff

function), while the lender’s payoff function is a combination of riskless debt and a short put

option position (resulting in a concave payoff function).11 When the debtholder and equityholder

11 Call and put options have payoff diagrams that resemble the shape of a hockey stick. A long call position has a zero payoff when the reference asset value is less than the exercise price. However, the payoff increases dollar-for-dollar when the reference asset has a value in excess of the exercise price. In our example, the debt payoff, D1, is the exercise price to the equity. A long put option increases dollar-for-dollar when the reference asset decreases below the exercise price. This is why risky debt is characterized as a put option—as the asset value declines below the debt payoff amount, the equityholder gains by being able to put the asset to the lender in return for forgiveness of the

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payoff functions are added together, a 45-degree line results that is identical to the payoffs from

holding the unlevered asset.12

Figures 6, 7, and 8 show payoffs to alternative supplemental financial claims in addition to the

payoffs to senior mortgage debt and inside equity. In all cases the senior mortgage debt payoff is

D1. For Figure 6, supplemental capital is structured as a subordinated debt claim with payoff

amount DS, resulting in a cumulative debt payoff of D1 + DS. The payoffs to the senior mortgage

debt position and to inside equity are the familiar concave and convex functions seen previously.

The payoff to supplemental debt by contrast has characteristics of both debt and equity. For asset

value payoffs in the range of [0, D1 + DS], the payoff function is convex and therefore equity-

like. For asset value payoffs in the range of [D1, ∞), the payoff function is concave and therefore

debt-like. This affirms the conventional view that subordinated debt is a hybrid financial claim

that has both debt and equity characteristics.

Figure 7 considers supplemental finance that is structured as outside equity with a pari-passu

(50/50) ownership structure on the residual asset value, V. In this case, the payoff functions to

inside and outside equity are identical.

Figure 8 displays payoffs when supplemental finance is structured as convertible debt, with debt

payoff DS and a conversion option that becomes in-the-money when asset value V exceeds VX,

where VX > D1 + DS. The payoff function to the convertible debt is identical to that of a

debt payoff amount. The lender is therefore short a put option. The lender’s total position is that of owning riskless debt plus a short put option. The credit risk premium included in the loan rate is the lender’s compensation for selling the put. The equity position (a call) plus the debt position (riskless debt plus a short put) equals the reference asset value. This equality relation is known as put-call parity. 12 This is another way of saying that the market value of the liabilities must equal the market value of the asset.

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subordinated debt position for all V ≤ VX, but identical to a pari-passu equity ownership

structure (i.e., conversion implying a 50/50 ownership split) for all V > D1 + DS with a

conversion exercise price of VX. Convertible debt is therefore a composite of subordinated debt

and outside equity—more equity-like than subordinated debt, but less equity-like than a pure

outside equity stake.

Figure 6

Payoff Diagrams to Inside Equity, Senior Debt, Junior Debt, and Asset Value

Payoff to Claimholder Asset Value Inside Equity D1 Senior Debt DS Junior Debt 0 D1 DS+D1 Asset Value, V

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Figure 7

Payoff Diagrams to Inside Equity, Outside Equity, Senior Debt, and Asset Value

Payoff to Claimholder Asset Value Inside and Outside Equity D1 Senior Debt 0 22.5° D1 Asset Value, V

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Figure 8

Payoff Diagrams to Inside Equity, Senior Debt, Convertible Debt, and Asset Value

Payoff to Claimholder Asset Value D1 Senior Debt Inside Equity

Convertible Debt DS 0 D1 DS+D1 VX Asset Value, V

Summary and Concluding Comments

When asked about optimal capital structure, the typical response from a commercial real estate

investor is “go for it—use as much debt as possible.” Although often the correct answer, when

asked why, the response is less compelling, often that “debt is cheaper than equity, so use debt.”

This answer, while not necessarily incorrect, is not terribly informative.

This paper has tried to articulate the economics underlying the market for outside finance in

commercial real estate, and therefore answer the optimal capital structure question. I established

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why a capital structure of inside owner equity and outside senior mortgage debt has worked well

historically in terms of producing a low weighted average cost of capital for property owners.

The effects of tight constraints on the supply of senior mortgage debt in the context of robust

demand for outside finance were then examined. Analysis demonstrated how a gap in the

traditional market for outside finance can come to exist and how supplemental financiers can

enter to plug the gap. A range of possible supplemental security designs were discussed,

including subordinated (mezzanine) debt, convertible debt, and outside equity.

The challenge in supplying supplemental finance is that risks and transaction costs are relatively

high, thereby restricting the kinds of financial claims that can be offered and limiting the set of

potential suppliers. Debt-like claims are generally favored over equity-like claims to address risk

and information issues, and an increased level of standardization is required to reduce

contracting and monitoring costs. The ability to fund senior as well as mezzanine positions in the

capital structure is particularly important in addressing hard-to-control investment risks and

contractual provisions that sometimes limit property owner access to supplemental financing

sources.

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