Commercial real estate projects or investments often require the buyer or developer to have a large amount of funding in place at the beginning of the project. It is not always possible to secure large sums of money, either through borrowing or issuing equity. Borrowers may be able to get conventional financing to meet part, but not all, of their needs. In those cases, borrowers may consider mezzanine loans to meet their needs.
For larger real estate deals, the buyer or investor will need to put together more than one source of financing. Lenders often do not want to provide 100% of the capital necessary because of the risks involved. At the same time, the borrower may not want to give up too much control or ownership interest by raising a large amount of equity for the deal. In between these two options stands mezzanine financing.
Mezzanine Financing Is Between Debt and Equity
The reason why this type of financing is called mezzanine is that its priority is at the middle level between equity and senior debt. If the borrower goes bankrupt, mezzanine debt holders will be paid before common and preferred equity holders, but they will take a back seat to owners of more senior debt. In other words, the financing serves as a way to bridge the gap between debt and equity.
Mezzanine financing is considered unsecured in that it is not collateralized with physical property. The collateral for the loan is the property owner’s interest in their own company. If the owner defaults on the loan, then the lender will become a part owner of the company, assuming that there was enough equity to first pay back other senior secured debt holders. In other words, the lender does not have the ability to take control of the property itself, but it does have the right to take partial control of the company.
Mezzanine Loans Fund Part of a Real Estate Investment
Real estate buyers will take out mezzanine loans when they are trying to fund a specific project. In some cases, they may not be able to borrow as much money as they need to finance the project. When that happens, they may need to resort to more creative funding options, albeit ones that have a higher cost of capital. Mezzanine funding is considered a form of growth capital.
Like a convertible bond, a mezzanine loan has some hybrid features that can make it both a form of debt and equity. If the borrower defaults on the loan, the lender can take an equity stake in the venture, subject to the priority order listed below. That stake is converted to stock if and when the borrower cannot repay the money.
The Advantages of Mezzanine Funding
Mezzanine financing offers a number of advantages for borrowers in real estate transactions, including:
- As companies grow, they can restructure mezzanine loans into senior loans that have more advantageous payment terms, including a lower interest rate.
- Interest on the debt is a tax-deductible business expense.
- Borrowers can defer some or all of the interest if they are unable to make a payment.
- Borrowers can maintain their equity interest in the company since they do not have to issue stock to raise capital.
- The borrower may not be large enough to obtain sufficient senior debt.
Mezzanine loans can be a flexible instrument for the borrower. The two parties are often able to customize the terms of the loan. The borrower could negotiate a loan with a flexible repayment plan. Some mezzanine loans could have balloon payments at the end of the term. Given how customizable these instruments are, borrowers can shop around for more favorable terms.
Mezzanine Loans Make a Borrower’s Balance Sheet More Attractive
When it comes to the borrower’s balance sheet, mezzanine loans are listed as equity. This makes the balance sheet look better when the borrower is trying to qualify for additional financing. Prospective lenders will not see a company that is as debt-laden as one with all senior loans. However, borrowers need to be careful not to overleverage themselves because these loans must still be paid back, even if they show up on a balance sheet as equity.
From a borrower’s perspective, it may be able to obtain higher returns on an investment because it would otherwise not be able to afford a purchase without a mezzanine loan. The mezzanine loan usually represents only a small part of its capital needs—the part that it is not able to fund with more senior loans. In turn, the buyer keeps more of an ownership interest. If the buyer is forced to fund the entire transaction with mezzanine loans, it may not be financially viable.
Lenders Get Paid More for Mezzanine Loans
From the lender’s perspective, mezzanine loans provide a higher return than other types of debt instruments. Mezzanine loans will carry a higher interest rate because of the lower priority they receive in bankruptcy. The lender is compensated for the risk by being paid more. In some cases, lenders are paid substantially more than they would be for senior debt. It is not uncommon for some mezzanine loans to carry interest rates of up to 25%. These rates can lead to annual returns for mezzanine lenders in the 12% to 20% range.
Mezzanine lenders can have a large say in how a borrower runs their business. Some may insist on a board presence or restrictive covenants. The last thing a mezzanine lender wants is for a property buyer to go on a borrowing spree because that raises the lender’s risk while situated at the middle rung in terms of priority. The lender may also be able to impose balance sheet requirements on a borrower. A mezzanine lender has a strong interest in the borrower being financially sound because it will control the borrower if it defaults. (Though, in practice, many real estate mezzanine lenders take a more hands-off approach.)
Mezzanine financing is not necessarily right for every real estate deal. A borrower will need to determine whether the increased cost of a mezzanine loan is worth it. A lender must consider whether a borrower is worth the risk, even with the higher rate of return on the loan. Borrowers must carefully consider their financing—mezzanine or otherwise—because it can make or break an investment.
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