Real estate debt is lending secured by property: apartment buildings, offices, warehouses, hotels and shopping centers. Unlike a corporate loan, the lender's main concern is one asset: how much it's worth, and how much income it earns. Private credit funds commonly lend where banks are less active, such as mezzanine layers, properties in transition, or loans that need fast or flexible terms.
For analysts, real estate debt uses its own measures: loan-to-value, debt yield and debt service coverage. For LP-side analysts and IR teams, knowing where a fund sits in the property's capital stack, and how much equity sits below it, explains most of its risk. This lesson uses a US context; terms and legal structures differ in other countries.
The three key measures
Real estate lenders size and monitor loans using three ratios. All use net operating income (NOI): the property's rental and other income less its operating costs such as maintenance, insurance, management and property taxes, before debt payments.
| Measure | Formula | What it tells the lender |
|---|---|---|
| Loan-to-value (LTV) | Loan ÷ property value | How far the value can fall before the loan is at risk |
| Debt yield | NOI ÷ loan | The income return the lender would earn if it owned the property at the loan amount |
| Debt service coverage ratio (DSCR) | NOI ÷ annual debt service | How comfortably income covers interest and any principal payments |
LTV depends on a valuation, which is an estimate. Debt yield doesn't: it uses only the income and the loan, so it's harder to flatter with an optimistic appraisal or low interest rates. DSCR depends on the loan's rate and repayment terms. Lenders commonly look at all three.
The layers of the property capital stack
Senior mortgage loans sit at the top, secured by a first mortgage on the property. If the borrower defaults, the senior lender can foreclose: take control of the property through a legal process and sell it. Senior loans have the lowest LTV and the lowest rate.
Mezzanine loans sit below the senior loan. In the US, a real estate mezzanine loan is commonly secured not by the property but by a pledge of the ownership interests in the company that owns it. If the borrower defaults, the mezzanine lender can take over that company, often faster than a foreclosure, and step into the owner's shoes, subject to the senior loan. An intercreditor agreement sets out the two lenders' rights (PC101 3.1). Some structures use preferred equity instead of mezzanine, a similar economic position without a loan.
Equity is the owner's money, which takes the first loss.
Bridge loans are a different category: short-term loans, commonly a few years, for properties in transition. A building being renovated, repositioned or leased up may not yet earn enough income to support permanent financing. A bridge loan funds the purchase and often the works, and the owner plans to refinance into long-term debt once income is stable. Bridge lenders take business plan risk: if the renovation runs over budget or tenants don't arrive, the refinancing may not happen.
A worked example: Harrowgate Court
The following example is illustrative. Harrowgate Court is a fictional US apartment building worth $50m, with NOI of $3.0m. Hollin Bay Capital's real estate debt fund is considering the mezzanine loan.
| Layer | Amount | Cumulative LTV |
|---|---|---|
| Senior loan | $30.0m | 0%–60% |
| Mezzanine loan | $7.5m | 60%–75% |
| Equity | $12.5m | 75%–100% |
| Property value | $50.0m |
Debt yield:
- Senior: $3.0m ÷ $30.0m = 10.0%
- Through the mezzanine: $3.0m ÷ ($30.0m + $7.5m) = $3.0m ÷ $37.5m = 8.0%
DSCR on the senior loan: the loan is interest-only at 7%, so annual debt service is 7% × $30m = $2.1m, and DSCR = $3.0m ÷ $2.1m = 1.43x.
Adding the mezzanine lowers coverage for the whole debt stack. If the mezzanine were interest-only at 11%, it would cost $0.825m a year; total debt service would be $2.925m and combined DSCR only $3.0m ÷ $2.925m = 1.03x. That thin combined coverage is one reason mezzanine lenders charge more.
What a fall in value does
Now suppose Harrowgate Court's value falls 20%, from $50m to $40m, while the loans stay the same.
| Layer | Amount | Before ($50m) | After ($40m) |
|---|---|---|---|
| Senior loan | $30.0m | 0%–60% | 0%–75% |
| Mezzanine loan | $7.5m | 60%–75% | 75%–93.75% |
| Equity | $12.5m / $2.5m | 75%–100% | 93.75%–100% |
The senior LTV rises from 60% to 75%. The mezzanine now covers 75%–93.75% of value, so it sits much closer to a loss. The equity cushion has shrunk from $12.5m to $2.5m: the owner has lost $10m of its $12.5m, all of the fall in value.
If the value fell further, to $35m, a sale would repay the $30m senior loan and leave $5m for the mezzanine lender, which is owed $7.5m, before any sale costs. The mezzanine would lose $2.5m and the equity would be wiped out.
Income matters too. If NOI fell 20% to $2.4m, the senior debt yield would drop to 8.0% and the senior DSCR to $2.4m ÷ $2.1m = 1.14x. Values and income often fall together, because property values are commonly estimated from income.
How real estate lenders lose money
Losses tend to come from falling values, falling income, or both, often across a whole property type or region at once. Common pressure points:
- Refinancing risk. Many real estate loans are interest-only with the full balance due at maturity. If values have fallen or rates have risen, the borrower may not be able to refinance.
- Business plan risk. Bridge loans depend on a renovation or lease-up that may not go to plan.
- Sector shifts. Changes in how people work, shop or live can reduce demand for some property types for years.
A senior lender with a low LTV has a large cushion. A mezzanine lender's return is higher, but a moderate fall in value can move it from well covered to at risk, as Harrowgate Court shows.
Key terms
- Net operating income (NOI): property income less operating costs, before debt payments.
- Loan-to-value (LTV): the loan divided by the property's value.
- Debt yield: NOI divided by the loan.
- Debt service coverage ratio (DSCR): NOI divided by annual interest and principal payments.
- Senior mortgage loan: a loan secured by a first mortgage on the property.
- Mezzanine loan (real estate): a loan secured by a pledge of the ownership interests in the property-owning company.
- Bridge loan: a short-term loan for a property in transition, repaid by refinancing or sale.
- Foreclosure: the legal process by which a mortgage lender takes and sells the property.
Key takeaways
- Real estate debt is sized and monitored using LTV, debt yield and DSCR, all based on the property's value or NOI.
- At Harrowgate Court, the senior loan is at 60% LTV, a 10.0% debt yield and 1.43x DSCR; the debt yield through the mezzanine is 8.0%.
- A 20% fall in value to $40m pushes the senior LTV to 75%, puts the mezzanine at 75%–93.75% and cuts the equity cushion from $12.5m to $2.5m.
- US mezzanine loans are commonly secured on the ownership interests, not the property, and rank behind the senior loan.
- Bridge loans fund properties in transition and depend on the business plan and a successful refinancing.
This lesson is for educational purposes only and is not investment advice.