It’s common investing knowledge that lower perceived risk goes hand in hand with lower returns. Generally, stabilized assets have less perceived risk, as we explain below, and therefore, may yield lower overall potential returns for investors. However, an investment in mezzanine debt on a stabilized asset could present a healthy balance between risk and reward for investors.
What is a Stabilized Real Estate Investment?
A stabilized real estate asset is a property in which construction or renovation has been completed, it has reached a certain occupancy rate (typically above 90% of total units), and it achieves a strong net operating income that can support debt service.
Stabilized assets are attractive to real estate investors and lenders because there is no risk of construction delays or work stoppages, which can occur with properties under construction or assets that require major capital improvements.
Stabilized Assets vs Non-Stabilized Assets
Every stabilized asset starts out as a non-stabilized asset. As an example, a newly developed high-rise multifamily building that has recently completed construction and just started leasing units would not be considered a stabilized asset. It will become stabilized when the property reaches the 90% occupancy threshold and its rents are achieving market rates allowing it to support the property’s debt service.
Key differences between stabilized assets and non-stabilized assets are as follows:
Stabilized Properties
- 90%+ occupancy
- Units leased on market terms
- Construction or major capital improvements completed
- Less business plan execution risk
- Steady cash flow
- Lower overall yields to investors and lenders
- Eligible for permanent financing
Non-stabilized Properties
- Occupancy lower than 90%
- Construction or major capital improvements ongoing
- More business plan execution risk
- Bigger “pop” in value upon sale of property
- Higher overall yields to investors and lenders
- Eligible for construction debt or bridge financing
Stabilization is a crucial benchmark for investors in the lifecycle of a commercial real estate development because it allows the sponsor to refinance the project’s debt, converting existing higher-cost bridge or construction financing to cheaper permanent debt. This may result in equity investors receiving capital distributions.
Stabilized assets typically generate consistent cash flow. However, they generally don’t see a big windfall when the property is ultimately sold. Non-stabilized assets, on the other hand, especially in the case of ground-up development or value-add deals, typically see less steady cash flow during the hold period, but then may experience a large return upon a sale of the property.
Investments in Mezzanine Debt on Stabilized Assets
While stabilized assets can produce lower overall yields, there is a way in which investors can potentially earn solid returns while taking advantage of the reduced risk that these properties offer – through investments in a mezzanine loan on a stabilized property.
Mezzanine debt is a type of subordinated financing used to increase leverage – and levered returns – in a commercial real estate transaction. Mezzanine debt fits between common equity and senior debt in the capital stack, because it has priority of repayment over equity, but is subordinate to senior debt, which is why it commands higher interest rates.
Mezzanine debt can be obtained on any real estate investment class or strategy. However, a mezzanine debt investment behind a stabilized asset creates a unique risk-adjusted return opportunity for investors. This is because the stabilized property does not have construction risks and can produce steady income to support the debt service payments to avoid default. And while the risk is reduced, the mezzanine debt will return solid yields for investors because of its position in the capital stack.
This combination of mezzanine debt and stabilized assets can be attractive to investors who diversify their assets between debt and equity investments.