What Is Mezzanine Financing?

A mezzanine loan is a relatively large, unsecured loan (a loan that is not backed by a pledging of assets) with a maturity of at least five years. The loan carries a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business. Mezzanine loans are dependent on cash flow for repayment.

Mezzanine loans are similar to second mortgages, except that mezzanine loans are secured by a percentage of ownership of the project, a 2nd T.D. that owns the property, as opposed to the real estate.

By definition, a mezzanine loan is a type of hybrid financing with debt and equity, typically subordinate to any senior debt positions. Given its subordinate position, the lender customarily receives a much higher coupon rate than they would have on the senior debt. In addition to this higher rate, mezzanine financing usually contains a convertible feature, which allows the lender to realize any gains associated with a project's success, which could further increase the total yield. This is what makes mezzanine financing attractive to investors and lenders; the yield of an equity investment, with the protection of being in a creditor position.

Common mezzanine structures and terms

The most common type of mezzanine financing is used in stabilized properties. The mezzanine lender will take a subordinate, or junior, lien position, usually to a CLTV up to 85%. In this situation, the lender doesn't have any participation in equity in regards to the project's cash flow, nor does it have any say in the management of the project. Depending on the type of project, loan-tovalue ratios and borrower's strength, yields geenrally range from 9-13%, with terms msimialr to the senior note.

Participation note

Mezzanine lenders can arrange the loan as a participating debt instrument if the borrowers desire a better leveraging position. This is where it becomes a hbrid of debt and equity. Using this method, borrowers can generally achieve up to 90% CLTV, but relinquish some of the upside potential of a successful project. The mezzanine lender should get a tad bit lower coupon rate, but they can possibly increase their overall internal rate of return (IRR) by participating in the project's cash flow or receiving an exit fee once the project sells.

Preferred equity

Th preferred equity strucure is almost a 100% equity strategy. In this stuation, the borrower and lender sign a partnership or joint venture agreement, which details the party's roles, the equity ownership of each and any other transaction terms.

Mezzanine Financing Usage

Usage was mainly for corporate finance deals,but soon investors discovered many applications for mezzanine financing in commercial real estate. Stabilized properties, value-add and development are the most common types of transactions, each having its own individual traits, where mezzanine financing is best used.

Stabilized properties

In the case of stabilized properties, mezzanine financing is best if the property generates enough cash flow to pay the debt obligation of both the first mortgage and the mezzanine portion, plus any operating expenses, and still offer a return to the owner. When this is not the case, mezzanine financing usage is probably not proper.

Non-Stablized properties

Non-stabilized properties, are properties which do not have stable cash flow. This is due to many reasons. In common scenarios, a borrower has found a potential opportunity to creat value in a property and seeks a mezzanine lender for the funds needed to achieve their goal to create value and cash flow.

Developments

The type of transactions considered the riskiest are development projects. They are also the most challenging to structure and require the most due diligence on the lender's part. It is common in development deals that mezzanine financing be in the form of preferred equity rather than straight debt for stabilized properties. This is because of two main ingredients: the lender's desire to attain a higher IRR due to the risk; and the lender wanting the position to participate in the management of the project and be a joint decision maker.