What is mezzanine financing in real estate?
Mezzanine debt is used to provide funding for commercial real estate projects. It is a mix of equity and debt financing and often serves to make up the shortfall if the senior debt raised is insufficient to cover the project cost.
Real estate mezzanine loans have two distinctive features. First, these loans are unsecured. Second, the interest rate on mezzanine loans is higher than the rate paid to senior lenders. If the borrower defaults, mezzanine lenders may be unable to recover the money they have advanced. However, if the loan agreement permits, they could convert the debt obligation into equity.
At this stage, it is important to point out the difference between mezzanine debt and a (CELOC). The former is a loan taken by a commercial real estate developer to fund a project. A CELOC, on the other hand, is used to provide a commercial real estate owner with a loan secured against the equity held in a property.
Mezzanine financing vs traditional loans
Senior debt generally serves as the principal funding source for a commercial real estate project. If the amount raised through senior debt is inadequate, one of the real estate debt strategies available to the project sponsors could be to fund the shortfall by issuing additional common equity.
However, this approach has a downside. Adding more common equity financing in the capital stack can dilute the returns of existing equity holders. Fortunately, mezzanine loans offer a way out. Mezzanine lenders can step in and fund the shortfall left by insufficient senior debt.
Another crucial aspect of mezzanine debt financing needs to be highlighted. Although they are fundamentally loans, mezzanine loans are classified on the balance sheet as equity. This can make raising additional funding easier for the project sponsors.
How does mezzanine financing work?
Mezzanine debt is a form of subordinated debt, implying that mezzanine lenders would receive lower priority for payments if the borrower defaults. Nevertheless, mezzanine debt receives priority over preferred equity and common equity.
Another key feature of mezzanine debt is that if the borrower fails to meet its repayment obligations, the debt can be converted into equity interest if the loan agreement allows. In addition to an equity interest in the project, mezzanine debt holders can also gain some degree of control over managing the operational aspects of the property.
Mezzanine financing structure
Real estate mezzanine loans typically have the following attributes:
- Mezzanine loans are subordinate to loans from senior lenders. However, these loans receive priority over preferred equity and common equity.
- The interest rate on mezzanine loans is higher than the interest rate payable on senior debt.
- Mezzanine debt holders have the option to convert their debt into equity in the project.
- The mezzanine debt agreement terms typically outline the mechanisms through which mezzanine lenders may exit the transaction, such as repayment by a stipulated date or converting debt into equity.
Types of mezzanine financing
Let us examine the different types of mezzanine financing real estate structures:
- Subordinated loans: In the capital stack, these loans have a lower priority for repayments than senior debt. However, subordinated debt earns a higher interest rate to offset this disadvantage.
- Preferred equity: Preferred equity holders receive a fixed rate of return but do not have a lien on the property.
- Convertible debt: This can be converted into equity at the lender’s option.
Mezzanine loan example
The following example will show how mezzanine capital can boost the return earned by common equity investors.
Consider a commercial property that costs $8 million and has a net operating income of $750,000. A commercial bank agrees to provide a $5 million loan at an interest rate of 7% per year. That is the senior debt component of the capital stack. The interest payment on the $5 million loan is $350,000. The remaining $3 million of the property cost will come from common equity.
Here are the details of the transaction structure: (Remember that so far, in this example, the capital stack consists of only senior debt and common equity).
Now, let us examine how the transaction can be structured if the common equity component in the capital stack is reduced from $3 million to $2 million and the shortfall is addressed by introducing a mezzanine loan of $1 million at a 12% interest rate.
In the scenario where the capital stack has a mezzanine debt component, the return on common equity has increased from 13.33% to 14%.
Key factors to consider when securing mezzanine financing
When raising real estate mezzanine loans, project sponsors and developers should understand the implications of the following variables:
1. Interest rate
In addition to shopping around for the best interest rates, sponsors should also take into account when the interest is payable. Some real estate mezzanine loans allow a part of the interest payments to be made at the end of the loan period. Therefore, for instance, it is possible to pay interest at the rate of 12% every month on mezzanine debt that carries an interest rate of 14%, with the remaining 2% being paid at the end of the loan tenure.
The method of paying interest on mezzanine debt described above is known as payment-in-kind interest (PIK interest). The advantage of PIK interest is that you can defer payment of a part of the interest. The disadvantage is that the unpaid interest is added to the capital, increasing the total interest payable.
2. Prepayment charges
It is worthwhile to closely examine the prepayment penalties and charges payable to mezzanine debt lenders in the event of early payment. Excessive fees may serve as an impediment, potentially hindering your ability to repay the debt before its maturity date.
3. Transferability restrictions
Check if transferring company debt is possible without lender restrictions.
4. Provisions regarding change of control
Is there a clause in the mezzanine debt agreement that requires you to repay the loan if you transfer ownership in the company? Mezzanine debt agreements often include such a condition.
5. Other covenants
It is a good idea to carefully read the mezzanine debt agreement’s fine print. Scrutinize each clause and see how it can impact your operations. Borrowers should also familiarize themselves with the lender’s rights regarding the information to be furnished to them. You may be required to keep the lender updated regarding your financial position and your company’s operational performance.
6. Consequences of default
What are the rights of the mezzanine lenders in the event of default? Can they ask the borrower to pay off the real estate mezzanine loans immediately? Additionally, the agreement may stipulate that the borrower can take control of the company’s operations in case of default.
7. Regulatory and tax considerations
Seek professional help to understand the legal implications of real estate mezzanine loans. Consider engaging an experienced lawyer with extensive expertise in the commercial real estate industry. Also, consider hiring a tax advisor if required. You could face a situation where the mezzanine lender can opt for equity conversion. It is best to understand this step’s implications and prepare for the consequences.
8. Maturity date
The commercial real estate project should generate adequate cash flows to allow repayment of the mezzanine loans by their respective maturity dates. It is essential for borrowers to match their cash flows with their repayment obligations. Borrowers should adopt a conservative approach and consider maintaining a cash buffer so that they can meet their financial commitments even if the project faces some unexpected expenses.
One option for borrowers is to opt for a longer loan term. This would give them more time to repay the mezzanine loan. The disadvantage of this approach is that it would increase the total interest payable over the term of the loan.
9. Convertible clauses
The mezzanine debt agreement may provide for the conversion of the loan into equity upon fulfilling certain predefined conditions. Borrowers should prepare for this eventuality.
10. Negotiating the best terms
Carefully review the loan agreement before finalizing the terms, and remember to ask for concessions or changes that favor you. It is important to recognize that a clause in the loan agreement that can have a critical impact on your business, could be relatively inconsequential from the point of view of mezzanine debt investors. A sound negotiating strategy would involve bargaining hard to ensure that the agreement contains clauses that favor your interests to the greatest extent possible.
11. Call option
Does the mezzanine loan agreement contain a call option clause that allows the lender to demand repayment before the due date? It is advisable to understand the conditions under which the lender can exercise this option to ensure you are adequately prepared should such a contingency arise.
12. Risk evaluation and reduction
Pay special attention to the mezzanine loan agreement clauses that specify the steps the lender can take in the event of borrower default. Develop a strategy to mitigate the potential impact of these actions.
Pros and cons of mezzanine financing
It is crucial for both mezzanine lenders and project sponsors to thoroughly evaluate the benefits and potential drawbacks of real estate mezzanine debt before opting for this funding structure. Below, we examine the pros and cons of mezzanine loans from the perspectives of both lenders and borrowers.
Pros and cons for lenders:
| Pros | Cons |
| Earning a higher return on the CRE portfolio by investing in mezzanine loans | Mezzanine loans are a form of subordinated debt and, hence, not as secure as senior debt |
| Conversion of debt to equity if the agreement permits | The level of risk increases if there is a market downturn |
| Operational control of the project in specific circumstances | Repayment is dependent on the borrower’s ability to sustain operational performance |
Pros and cons for borrowers:
| Pros | Cons |
| Does not have a first lien on the property | High-cost loan |
| Provides an excellent way to bridge the funding gap | May result in the dilution of equity |
| Classified in the balance sheet as equity financing, making the raising of additional loans easier | Mezzanine debt investors may have the option to take over some operational control |
What returns can you expect from mezzanine debt investments?
Mezzanine loans are popular with investors as they offer high returns. As a general rule, investors can expect a return on investment that exceeds the return typically earned by senior debt providers, reflecting the higher risk associated with these loans. Although interest rates can vary, mezzanine debt typically earns an annual return of 12% to 20% or even more.
The bottom line
Mezzanine loans are an excellent financing option for commercial real estate project sponsors and developers trying to bridge a funding gap in the capital stack. Although they can be high-cost, borrowers like the fact that they are available without the need to provide security.
From the lender’s perspective, mezzanine loans have two key advantages: They can earn a high return and can provide the possibility of being converted into an equity stake in the borrowing entity.
