In architecture terms, the “mezzanine” floor in a building is an “intermediate floor between the main floors of a building.” In a commercial real estate financing context, the concept is the same.
In this article, we’ll describe mezzanine financing, including the key features of mezzanine debt and the benefits and risks of mezzanine financing in commercial real estate.
What is Mezzanine Debt in Commercial Real Estate?
Mezzanine debt is a type of commercial real estate financing that sits “between” the senior debt provided by a lender and the equity provided by investors.
The key features of mezzanine debt in real estate are:
- Amount: The amount of mezzanine debt needed is highly dependent on the amount of debt that a lender is willing to provide and the amount of money that can be raised from investors. Relative to senior debt, the amount is usually much smaller.
- Security: Mezzanine debt could be unsecured. Or, it could be secured by a second position lien on the property to be purchased. It is “subordinate” to senior debt, which means that mezzanine lenders holders are second in line to be repaid. Their claim is behind senior debt holders, but ahead of equity holders.
- Risk: Because it is subordinate to senior debt, mezzanine debt is considered to be a riskier form of lending/investment. As a result, investors demand a higher return/interest rate.
- Term: The term of a mezzanine loan can vary, but it is typically shorter than the term of the senior debt.
- Repayment: The payments on a mezzanine loan are usually interest only.
In order to understand how mezzanine financing for real estate works, it is helpful to discuss it in the context of the commercial real estate capital stack.
Mezzanine Debt and the Capital Stack
In order of repayment, the four components of the capital stack are:
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
From the order, it can be seen that mezzanine financing in real estate sits in the middle of the capital stack (hence the term mezzanine). To illustrate how it works, an example is helpful.
Example of How Mezzanine Debt Works
Suppose that an investor was going to purchase a property for $5,000,000. They are able to obtain senior debt of $3,500,000 and raise $1,000,000 in equity from investors (preferred and common). This is a typical situation where mezzanine financing could be utilized. A $500,000 mezzanine loan would bridge the gap between the senior loan and the equity to complete the financing “stack” needed to make the purchase.
The loan in this example could potentially come in two forms.
Types of Mezzanine Financing
Broadly, there are two types of mezzanine financing: pure debt or a hybrid of debt and equity.
1. Pure Debt
If it comes in the form of pure debt, it means that the lender advances the funds requested and they are repaid with interest, without an equity position in the company that purchases the property.
2. Hybrid of Debt and Equity
In a hybrid structure, the funds are advanced to the borrower and repaid as agreed. However, the mezzanine lender retains some amount of equity in the deal, which means that they get to participate in the upside upon sale (if there is one).
Given the higher interest rate on mezzanine financing, it may be tempting to wonder why investors would use this option to finance a real estate transaction.
Reasons to use Mezzanine Financing in Real Estate
There are three potential reasons that an investor would use mezzanine financing in the purchase of a commercial property:
1. The Investor Has To
There are limits to the amount of debt and equity an investor can raise. These limits may be driven by the senior lender’s policy or due to some riskier aspects of the deal. Mezzanine lenders are used to more risk and may be willing to step in and provide the needed financing…at the right price.
2. It Can Boost Returns
The more debt an investor is able to use in a purchase, the less of their own money they need. The less of their own money used, the higher the return on the funds invested. While mezzanine debt can boost return, it can also raise the risk profile of the deal.
3. It Reduces The Amount of Equity Needed
Every dollar worth of equity raised means that the investor has to sell a share of the company used to purchase the asset. In pure debt form, mezzanine financing reduces the amount of the needed equity raise and allows the investor to retain a higher percentage of equity ownership in the deal.
For these reasons, it can be tempting to think that using mezzanine financing in every deal is a good idea. It could be, but there are also several very important risks that borrowers and investors should be aware of.
Risks of Mezzanine Financing
Likewise, there are three main risks when mezzanine financing is used in a real estate transaction.
1. The Cost of Capital Goes Up
Higher interest rates mean that the property has to produce more cash flow to pay for the debt service. This also means that there is a smaller margin for error before the property goes cash flow negative.
2. Not In a Senior Position
The benefit of a senior loan is that they are in first position to be repaid in the event of bankruptcy or foreclosure. The holder of mezzanine financing is only entitled to whatever funds are left over after the senior lender has been repaid. In a bankruptcy or foreclosure, there may or may not be enough to be repaid in full. This is the risk of being in a subordinate position.
3. High Fees
In addition to the higher interest rate, a mezzanine loan also comes with high fees. Usually, this is in the form of an origination fee that can reach 3%+ of the loan amount. Again, this increases the total cost of capital, which means that the property has to perform well enough to service all debts.
To illustrate the risk of a mezzanine investment, an example is helpful.
Example of Mezzanine Financing
Whether investing in a pool of mezzanine capital or pursuing an investment opportunity with this type of financing, the risk is highlighted in a theoretical bankruptcy scenario. Continuing the example from above, suppose the real estate investor purchases the real estate property for $5,000,000 and finances it with a $3,500,000 senior loan, $500,000 in mezzanine financing, and $1,000,000 in common equity.
Now assume that the economy enters into a contraction causing rents to fall and vacancy to rise. As a result, the property’s income also falls to a point where it is no longer sufficient to service both the senior commercial mortgage and the mezzanine loan. As a result, the senior lender forecloses on the property and is forced to sell it into a down market. The property sells for $3,250,000.
Because the senior lender is first in line to be repaid, they will get all of the sale proceeds and they will still take a $250,000 loss. Both the mezzanine and equity investors will lose their entire investment.
This type of risk is why the interest rate and origination fees for mezzanine financing in real estate are high. There is less certainty about getting repaid in full and there must be compensation for this uncertainty.
Summary & Conclusions
Mezzanine financing is a type of financing used in certain real estate deals. It is meant to fill the gap between a senior loan and the amount of equity that can be raised.
The benefits of using mezzanine financing in a real estate investment is that it can boost returns by reducing the amount of equity needed in the deal.
But, mezzanine financing also comes with risks. It raises the total cost of capital in the transaction and they are second in line to be repaid in the event of a bankruptcy or foreclosure. In addition, it can come with high fees, which means that the property needs to perform well enough to cover the debt service for both the senior and mezzanine loans. These factors should be considered in the underwriting process.
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