Relative Position of Debt

When taking loans or investing in debt, it’s important to know and understand how the seniority of the debt is structured, since this determines who gets paid first in the event of a default, and therefore the risk/benefit ratio of each debt holder on a given property.

For most residential properties, banks and other institutional lenders (for example, credit unions) generally insist on a primary, or senior-most position. This means that if a property has to be sold to cover debt on which the owner has defaulted, the bank gets paid from those proceeds first, until all unpaid principal and interest is satisfied. If there’s money left over, it is then used to pay subordinated, or junior, debt (again, any unpaid principal and interest). In the unlikely scenario that sale proceeds exceed all the unpaid liabilities to all lenders on the property, the owner/borrower would be entitled to whatever is left.

This arrangement naturally dictates the expected return on investment that each party is willing to tolerate in such a scenario. Since the bank is owed first, it is taking the least risk, and therefore accepts a ~3-6% annualized return on investment (ROI; whatever the interest rate happens to be), plus any fees it charges (for example points or other origination fees) in exchange for its services. Other lenders with junior/subordinated debt positions (often private lenders), who are by nature in a riskier position than the bank, will generally insist on a comparatively higher annualized ROI (usually somewhere in the 7-12% range) to justify the increased exposure to risk. Importantly, this is by no means a foolhardy risk/reward position to take. In fact, major financial institutions and advisors recommend including subordinated debt as part of a balanced portfolio, and Coldstream Partners is built on the premise that such debt is a sound investment!

Lastly, the borrower of such debt is the party with the highest risk, as well as the highest potential rate of return. S/he is more or less by nature projecting a total annualized return higher than what s/he is paying to any lender (whether a bank or individual), in order for it to be a profitable deal.