Key takeaways

Subordinate mortgages offer entrepreneurs financial flexibility and enable more efficient capital utilization through:

• Equity release: Capital is made available for new investments, allowing for quick reactions to market opportunities, such as acquiring additional properties.
• Increased leverage: Entrepreneurs can reduce their equity while increasing their return on equity. In our calculation example, the return on equity increases by approximately 30%.
• Tax advantages: The tax deductibility of interest reduces the tax burden and enhances the return on equity.
• Optimized financing conditions: Subordinate mortgages help secure better terms for primary mortgages, optimizing overall financing costs.

Introduction

In our previous article, "Private Real Estate Debt: An Attractive Opportunity for Institutional Investors," we discussed subordinate loans on (existing) real estate and how institutional investors can invest in this asset class. In this article, we focus on the borrower's perspective and the reasons for accessing subordinate mortgages on their real estate (portfolio).¹

Before discussing these reasons, it's essential to understand who typically qualifies as a borrower of subordinate mortgages. This often includes entrepreneurs owning multiple properties who want to deploy their capital more efficiently. Examples include:

• Real estate investors: Expanding their real estate portfolios.
• Builders and developers: Financing new projects or bridging market phases with lower selling prices.
• Entrepreneurs with existing properties: Requiring liquidity for new ventures.

Overview

In this context, borrowers increasingly look for ways to maximize their return on capital and respond flexibly to market opportunities. A popular strategy is taking out subordinate mortgages. But what makes this form of financing so attractive? Here are the four main reasons why a subordinate mortgage can make sense and how it impacts equity returns.

1. Equity release and flexibility for new investments

A subordinate mortgage releases the necessary equity for other projects, providing the flexibility to quickly respond to new market opportunities without relying on tied-up equity. In a highly competitive real estate market, this offers a valuable competitive advantage. This additional flexibility is particularly attractive to developers who must respond to unforeseen costs or seize attractive purchasing opportunities.

2. Increased leverage effect

Subordinate mortgages allow entrepreneurs to reduce equity while still gaining access to additional capital. This "leverage effect" enables optimal use of equity, enhancing returns per invested Swiss franc.

3. Tax advantages

In Switzerland, interest payments on debt, including subordinate mortgages, are tax-deductible. This means entrepreneurs can reduce their tax burden through debt financing – often making a subordinate mortgage more attractive than solely relying on equity.²

4. Optimized terms for primary mortgages

Maintaining loan-to-value ratios (LTV) is often a prerequisite for better terms from banks. By taking out a subordinate mortgage, entrepreneurs can maintain or increase their LTV while securing more favorable terms on their primary mortgage. The effect may vary depending on the interest rate environment and risk margin of the primary mortgage.

Example: Equity leverage with and without a subordinate mortgage

The following example illustrates equity release, leverage effect, and tax advantages, showing how the equity return can increase by almost 30%:

Conclusion

After accounting for interest payments and tax effects, the equity return improves by nearly 30% from 12.9% to 16.6% due to the subordinate mortgage. The combined effect of tax savings and leverage makes subordinate mortgages an effective strategy for boosting returns, even with higher interest rates. Additionally, the borrower has CHF 1,000,000 in free equity available for new investments or acquisitions.

Over CHF 55 Million in subordinate mortgages provided

Artemon Capital Partners has arranged over CHF 55 million across 25 transactions in subordinate mortgages (minimum loan volume of CHF 1 million). This extensive experience shows borrowers increasingly rely on this financing form to maximize returns and maintain financial flexibility.

Appendix: Detailed explanation of the example

The appendix explains the impact of the change in LTV and the resulting 30% equity return boost through subordinate mortgages. Key points include tax-deductible interest and gross annual returns of 5% on the purchase price.

1. Annual gross return: The property generates a return of 5% p.a. of the purchase price from rent income, which corresponds to CHF 500,000.
   
2. Interest payments:
   • Bank mortgage (2% interest): CHF 7,000,000 x 2% = CHF 140,000.
   • Subordinate mortgage (7% interest): CHF 1,000,000 x 7% = CHF 70,000.
3. Tax-Deductible interest payments: Total interest costs are tax deductible.
   • Without subordinate mortgage: CHF 140,000.
   • With subordinate mortgage: CHF 140,000 + CHF 70,000 = CHF 210,000.
4. Tax savings: Interest payments x tax rate (20%):
   • Without subordinate mortgage: CHF 140,000 x 20% = CHF 28,000.
   • With subordinate mortgage: CHF 210,000 x 20% = CHF 42,000.
5. Net income after interest and tax effects: Gross return - interest payments + tax savings:
   • Without subordinate mortgage: CHF 500,000 - CHF 140,000 + CHF 28,000 = CHF 388,000.
   • With subordinate mortgage: CHF 500,000 - CHF 140,000 - CHF 70,000 + CHF 42,000 = CHF 332,000.
6. Return on equity (RoE): Net income is divided by the equity used:
   • Without subordinate mortgage: CHF 388,000 / CHF 3,000,000 = 12.9%
   • With subordinate mortgage: CHF 332,000 / CHF 2,000,000 = 16.6%

Footnotes

¹ A subordinate mortgage – also referred to as mezzanine financing in this context – is a form of real estate financing that ranks behind the primary mortgage (or bank mortgage) and is secured by a property (or land). The article primarily refers to subordinated mortgages on existing income-generating properties and not on project developments.

² From the perspective of weighted average cost of capital (WACC), both debt financing and the tax effect typically reduce the weighted cost of capital. As a result, the gross return of a property exceeds the capital costs, leading to a positive net present value.

³ In this example, we assume that the entrepreneur has an average tax rate of 20%.

Disclaimer
This commentary is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities or financial instruments. The information contained herein is not intended to provide investment, legal, or tax advice, and should not be relied upon in making any investment decisions. Investing in securities involves risks, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should carefully consider their own investment objectives, risk tolerance, and financial situation. The views and opinions expressed in this document are those of the author(s) and do not necessarily reflect the views of Artemon Capital Partners. Artemon Capital Partners does not guarantee the accuracy or completeness of the information provided herein, and disclaims any liability for any errors or omissions. Investors are advised to consult with their financial advisor or other qualified professionals before making any investment decisions.