Subordinated debt is debt that is repaid only after senior debt is paid in full. It sits below senior debt in the capital stack, carries more risk, and is priced higher.
The longer version
Subordinated debt, also called junior or sub debt, ranks behind senior debt for payment and for recovery in a default. Senior debt is the first-priority loan, in commercial real estate usually the first mortgage. Anything ranked behind it is subordinated, and its holder is paid from what is left after the senior lender is whole.
In a real estate capital stack the order runs senior mortgage, then subordinated debt, then preferred equity, then common equity. Subordinated debt takes several forms: a B-note in an A/B structure, secured by the same mortgage but junior to the A-note; mezzanine debt, secured by a pledge of the ownership interests in the borrower rather than the property; and a second mortgage, where the senior lender allows one.
The ranking is set by documents, not by labels. An intercreditor agreement between the senior and junior lenders sets payment priority, cure rights, purchase options and who may enforce, and a subordination agreement records that one interest yields priority to another. Many senior lenders prohibit secondary financing outright, so subordinated debt is usually negotiated into the deal from the start.
For the senior lender, subordinated debt behind it adds leverage to the property, which raises combined loan to value and thins the sponsor's equity cushion. For the junior lender, it means a higher return for a position that absorbs losses before the senior does. Both sides read the combined numbers, not just their own tranche.
Common questions
- What does subordinated debt mean?
- Debt that is repaid only after senior debt is paid in full, both in normal payments where the documents say so and in a default or liquidation. It carries more risk than senior debt and a higher rate.
- What is the difference between senior debt and subordinated debt?
- Senior debt has first claim on payments and collateral. Subordinated debt is paid from what remains after the senior lender is whole. In commercial real estate the senior debt is usually the first mortgage.
- Is a mezzanine loan subordinated debt?
- Yes. A mezzanine loan is subordinated to the mortgage. It is secured by a pledge of the ownership interests in the borrowing entity rather than by the property, and an intercreditor agreement with the mortgage lender sets its rights.
- How does subordinated debt affect a senior lender?
- It adds leverage behind the senior loan, raising combined loan to value and reducing the sponsor's equity cushion. Senior lenders control this through intercreditor terms, combined leverage limits, or by prohibiting secondary financing.