Real estate investment management companies frequently use a variety of sources of capital within their capital stacks to finance the purchase of a new building acquisition or a development project. Real estate mezzanine financing, also known as mezzanine lending, is one of those sources of capital. Mezzanine loans offer capital in the form of subordinated debt to investors or borrowers. Continue reading to discover more about mezzanine loans, including what they are, how lenders and investors can benefit, examples, and more.
What is a Mezzanine Loan in Commercial Real Estate? (Definition)
Investors may take on a real estate mezzanine loan as a form of financing to support acquisitions or development projects. Within the capital stack, mezzanine loans are below senior debt but are given precedence over both preferred and common equity. Mezzanines, which are located one level above the ground floor of buildings, are where these loans get their name.
Investors can use mezzanine loans to close the financing gap when senior debt is insufficient to cover the costs of a purchase or development project. By providing additional capital without selling the maximum amount of equity, mezzanine bridge loans assist investors in increasing their return on investment. Real estate mezzanine loans, which combine debt and equity financing, are typically unsecured, meaning they don’t call for tangible collateral. But lenders can recover their interest returns in the form of equity instruments if a borrower defaults or goes bankrupt.
Mezzanine Loan Interest Rates Are Higher Than Other Financing Options
When it comes to selling equity, mezzanine financing gives investors more options, but because they’re unsecured, lenders assume more risk. Mezzanine loans typically have shorter terms and higher interest rates than traditional bank loans because of this. Normal rates are in the double digits, but some can reach 30%. However, this trade-off is typically acceptable given that investors can maintain optimal ROI over the long term. Normally, the loan’s principal is not amortized, so interest payments are the only way to make payments.
Subordinated Debt, With Equity Instruments On Standby
The capital stack determines the order in which lenders and stakeholders are paid in the event that a borrower defaults or declares bankruptcy.
Senior debt lenders, which typically lend the lion’s share of capital for a property’s purchase, are at the top of the capital stack, meaning they receive payment first. Mezzanine loans fall right after senior debt in this hierarchy. When borrowers can’t afford to make payments on a mezzanine loan, lenders maintain the right to seize equity instruments or control of the property, depending on the agreement’s terms. Mezzanine lenders will receive payment before common and preferred equity shareholders, though.
Mezzanine Loan Example: Offsetting Equity Dilution
Let’s look at an example of a $5 million multifamily property acquisition to fully comprehend how mezzanine financing in real estate operates. Let’s say you were approved for a $3 million mortgage, also known as senior debt, covering the majority of the acquisition’s cost. If the property generates $400,000 in net operating income and senior debt payments stay the same at $225,000,
You could sell equity to raise the final $2 million needed for the purchase, but doing so would reduce the property’s equity returns. Instead, you could raise money through equity sales to pay for some expenses while obtaining a mezzanine loan to pay for the rest. Let’s examine how each scenario’s costs and returns would be different.
$5 Million Acquisition Deal Without Mezzanine Debt:
| Senior Debt/Mortgage | $3 million |
| Equity | $2 million |
The property would produce $175,000 in net cash flow after paying down senior debt, making the return on equity 8 75%. You could use a mezzanine loan to supplement the borrowed equity in order to increase that return on equity.
The percentage of equity in the capital stack with a real estate mezzanine loan would be significantly lower.
$5 Million Acquisition Deal With Mezzanine Debt:
| Senior Debt/Mortgage | $3 million |
| Equity | $1.25 million |
| Mezzanine Debt | $750,000 |
You would be required to pay $50,000 for the mezzanine debt in addition to the $225,000 senior debt payment. The property’s net cash flow would be $125,000 as a result. Your return on equity would rise to 10% despite the decline in net cash flow, meaning you would continue to make a larger share of profit over time.
| Capital Stack | Purchase Price | Senior Debt | Equity | Mezzanine Debt | Net Operating Income | Senior Debt Payment | Mezzanine Payment | Net Cash Flow | Return on Equity |
| With Mezzanine Debt | $5,000,000 | $3,000,000 | $1,250,000 | $750,000 | $400,000 | $225,000 | $50,000 | $125,000 | 10% |
| Without Mezzanine Debt | $5,000,000 | $3,000,000 | $2,000,000 | $00.00 | $400,000 | $225,000 | $00.00 | $175,000 | 8.75% |
Why Use Mezzanine Financing: Benefits For Investors & Lenders
Real estate mezzanine loans could be advantageous no matter which side of the transaction you are on. This breakdown examines the advantages of a mezzanine loan’s structure for lenders and potential advantages for investors borrowing capital.
For Investors & Commercial Real Estate Property Buyers
Real estate mezzanine loans can be a crucial tool for investors in a pinch, enabling them to raise capital while preventing further equity dilution and allowing them to keep a larger ownership and profit stake.
Mezzanine lenders can gain from offering equity-backed financing to aid investors in closing a deal despite the high risk:
Achieve Team-Wide Visibility Into Acquisitions & Lending Pipelines
Deals in your pipeline that are developing can be a sign of your company’s high potential, but only if you can allocate your resources effectively. Without access to deals and related data, it is impossible to anticipate and respond to changing market trends.
To learn how your team can monitor deals changing in real time and the operational efficiencies that complete connectivity introduces, watch Dealpath’s webinar.
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FAQ
How does a mezzanine loan work?
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the option to convert the debt into an equity stake in the company in the event of default, typically following the payment of venture capital firms and other senior lenders. It exists between senior debt and equity in terms of risk.
Is a mezzanine loan a mortgage?
A mezzanine loan is backed by the pledge of equity interests in a company that owns real estate and is subject to the Uniform Commercial Code (UCC), unlike a mortgage loan, which is secured by real estate.
What is an example of a mezzanine?
Mezzanine debt structures are most common in leveraged buyouts. For instance, a private equity firm may want to borrow $100 million to buy a company, but the lender only wants to contribute $80 million, or 80% of the value.
What are the advantages of mezzanine financing?
Mezzanine debt can create a more effective structure that lowers the after-tax cost of capital, is less dilutive than equity financing, and improves the return on equity because common equity is the most expensive form of capital and is not tax deductible.