Mezzanine debt helps commercial real estate investors bridge the gap between their equity and the senior debt a lender will provide them. It provides the possibility to earn a higher return rate on their investment. It’s a form of subordinated debt. Now, let’s go through mezzanine debt commercial real estate in detail.
What is a Mezzanine loan?
Mezzanine financing got its name from the mezzanine floor of a building, which is right above the ground floor. This architectural definition is a metaphor for mezzanine financing in real estate investments. Actually, it’s right above the senior debt in the capital stack of an investment.
For financing, an acquisition or expansion project mezzanine loans are taken by the investors as additional debt. This reduces the equity amount an investor needs when putting together funding. Mezzanine financing is comprised of certain characteristics as follows:
- It’s subordinate to senior loans, but it has priority over preferred and common equity in the event of bankruptcy.
- The interest rate is higher than senior debt.
- It’s typically not secured by any collateral.
- It can be interest-only instead of having the principal amortized over the life of the loan.
- It’s often of a shorter duration than secured debt.
How does mezzanine financing work?
Mezzanine financing works to fill the gap between the senior debt financing available to fund a real estate deal and the equity an investor has available to put into the transaction. In a conventional real estate transaction, an investor might be able to cover senior debt for up to 80% of a property’s value, which covers 20% with equity, such as cash on hand.
If the borrower doesn’t have enough capital then they can either borrow from other equity investors or find some other funding source, such as preferred equity or mezzanine financing. Mezzanine debt is one of several bridge financing options available to borrowers, along with junior debt and preferred equity investors may carry a higher degree of risk.
For example, if an investor needs a construction loan to purchase a property for $5,000,000. They can take $3,500,000 as senior debt and raise $1,000,000 in equity from investors (preferred and common). In this typical situation, mezzanine financing could be utilized. A $500,000 mezzanine loan can bridge the gap to complete the balance sheet needed to make the purchase.
Characteristics and benefits of Mezzanine Debt:-
The main characteristics and benefits of Mezzanine debt include:
- The main benefit of mezzanine debt is that it is an additional debt an investor takes on to finance a commercial real estate venture. This, it reduces the preferred equity investment when collecting funding for an acquisition or expansion project.
- In the real estate capital stack of an investment, the mezzanine debt comes right above the senior debt. This subordination gets paid after all senior debts have been settled. Mezzanine debt gets priority over preferred and common equity in the event of bankruptcy. All the income must go to pay the mezzanine debt once the senior debt and operating expenses are paid. If the payments are due then the mezzanine financing lender has the right to seize the equity position and take over the property and the mortgage.
- The mezzanine financing has a higher interest than senior debt and the investor can earn a higher return rate. The return stands between 12% to 20% annually, and it depends on the project’s risk. Though it’s not as low as secured debt, nor the cash flow is equal to equity, mezzanine lenders still can offer attractive risk-adjusted returns.
- An indirect benefit of using mezzanine financing is its impact on the company’s leverage ratio. The leverage ratio is used to calculate several factors such as the debt-to-equity ratio.
Debt-to-equity ratio = Total Shareholders’ Equity / Total Liabilities
This ratio determines the amount of shareholder’s equity and total liabilities in the form of loans used by the company.
- Lastly, the most important benefit that mezzanine financing offers is the reduction in the equity requirement. An investor doesn’t have to utilize the equity for a single deal. They can take the loan and use the rest amount for other opportunities, further leveraging their returns. Also, the mezzanine loan assists those who do not have enough capital but still do not want to miss an opportunity. This benefit helps to bring on other equity financing partners and dilute their ownership interest.
Is Mezzanine financing the correct choice for every deal?
Before investing in commercial real estate, investors should be aware of the advantages of mezzanine loans and their benefits. To assess the maximum gain all the details of financial instruments are needed to be evaluated. Mezzanine financing offers a great way to cover the difference between the equity investors have to put into a deal and the senior debt financing secured from lenders.
Mezzanine debt service generally targets higher returns than senior lenders. These loans have a high-risk profile but still, enhance the return potential. So, if you want to decide whether a mezzanine debt is the best option then you have to measure the pros and cons of utilizing this financial tool in this real estate transaction.
The Lilypads Bottomline
An investor must check every aspect of mezzanine financing to decide whether it is their best option or not. It reduces the amount of equity required to put up in a transaction and also boosts their returns on the said investment, it also increases their risk.
It raises the leverage level of the property which implies both sides, it increases profit when the investment pays off and also results in losses if something goes wrong.
Further, with less equity to cushion the blow of losses, real estate investors risk a complete loss of capital they put into the deal. In the case of long-term investments, there is less certainty for commercial real estate mezzanine lenders to get the full return. And also there must be compensation for this uncertainty. Before going forward both sides should be considered.