What is a Mezzanine Loan in Real Estate, and How Does It Work?
Acquiring new commercial real estate is capital-intensive, and sometimes investors need more capital than they can obtain through primary loan programs. Investors may be able to raise more capital through dilution — or they might take on a mezzanine loan. Here’s what a mezzanine loan in real estate is.
What Are Mezzanine Loans in Real Estate?
Mezzanine loans provide subordinate financing for new real estate acquisitions and developments. These loans are used when primary financing doesn’t cover the full cost of a purchase or project.
Subordinate means that mezzanine financing takes a backseat to other, primary financing in the capital stack. Should a borrower default, the primary loan(s) will take preference. A mezzanine lender will only collect after all primary loans have been satisfied.
Mezzanine financing does take priority over preferred and common equity, though. The term “mezzanine” stems from the balcony that sits one level above the ground floor. These loans are one step up from the proverbial ground floor of equity.
The capital stack for a multi-loan acquisition or development that has a mezzanine loan is:
1. Primary financing
2. Mezzanine financing
3. Preferred equity
4. Common equity
When Are Mezzanine Loans Used for Real Estate?
Mezzanine loans can be used for both new construction, and the acquisition of existing properties. They’re available for multi-unit residential, commercial, industrial and other properties.
Borrowers use mezzanine financing to fill the financial gap if primary financing doesn’t cover the full cost of development/acquisition.
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How Are Mezzanine Loans Structured?
Mezzanine loans are usually short- or medium-term loans with high interest rates. Terms around five years are common, and interest rates can be as much as 30 percent. They’re usually not amortized, so only interest payments are due during the loan’s term.
Lenders may structure these loans as secured or unsecured. Even when unsecured, a lender can usually still seize the property or other equity instruments if the borrower defaults. Secured and unsecured mezzanine mortgages take second priority to primary loans, which usually are secured.
Some of these loans also provide the lender with a small amount of equity in the financed property.
Examples of Mezzanine Loans in Real Estate
To understand why borrowers might take on a mezzanine loan, consider the following examples. Assume that a borrower has a financial gap after securing primary financing, but that gap can be filled through equity dilution or mezzanine debt.
A borrower is purchasing a $5 million property that has a net operating income o $400,000. The borrower has secured primary financing in the amount of $3 million, leaving a $2 million gap. The primary financing has monthly payments of $200,000.
The borrower could combine the $3 million in primary financing with $2 million of partner equity. They alternatively could use a mezzanine loan of $750,000 too. Thus, the financing options are:
|Purchase Prize||Primary Financing||Mezzanine Financing||Equity|
|$5 million||$3 million||$0||$2 million|
|$5 million||$3 million||$750,000||$1.25 million|
Using these numbers, the property’s financials would be as follows:
|Financing Structure||Primary Debt Payment||Mezzanine Debt Payment||Net Cash Flow||Return on Equity|
As these numbers show, mezzanine loans reduce cash flow but can increase return on equity. The return may outweigh the additional interest and reduced operating income. Borrowers should consider any other financing (e.g. specialized green loan programs) before using one of these loans, however, as programs might have strict DSCR requirements.
Basic Types of Mezzanine Financing
Mezzanine lending may be structured as a pure debt deal, or as a hybrid of debt and equity. Prue debt mezzanine loans are repaid according to their terms. Hybrid debt loans are repaid accordingly but also give the lender a small equity interest. The equity portion offers the lender a chance to receive some of the profits should the property be sold.
The Pros and Cons of Mezzanine Loans for Borrowers and Lenders
The unique structure of mezzanine loans gives them both advantages and disadvantages. Borrowers and lenders alike see pros and cons.
Pros and Cons of Mezzanine Loans for Borrowers
Borrower Pros of Mezzanine Loans
- Can fill a capital gap without diluting equity
- Allows for greater leverage and potentially higher return on equity
- Listed as equity instead of debt on balance sheets
- Might be the only available way to bridge a capital gap
- Terms are often flexible
Borrower Cons of Mezzanine Loans
- Come with high interest rates
- Have high fees
- Debt service coverage ratio is decreased
Pros and Cons of Mezzanine Loans for Lenders
Lender Pros of Mezzanine Loans
- High interest rates can increase return on capital
- Equity share of a property might be available
- Mezzanine lenders sometimes can stipulate operating requirements
Lender Cons of Mezzanine Loans
- Take second priority to primary loans in the event of default
- Often high-risk loans with increased likelihood of default
- Frequently aren’t secured with collateral (but lenders may seize control)
Are Mezzanine Loans Secured?
Mezzanine loans typically aren’t secured. They might still allow a lender to pursue control or equity instruments in the event of default, however.
What is the Collateral for Mezzanine Debt?
Mezzanine debt often doesn’t have actual collateral, largely because it’d be subordinate to any primary financing collateral. This doesn’t necessarily preclude mezzanine lenders from pursuing control or equity instruments, though.
Who Can Provide Mezzanine Financing?
Many commercial real estate lenders offer mezzanine financing. There are those who specialize in mezzanine lending, while others offer mezzanine financing in addition to other commercial real estate loans.
Wrapping Things Up: Mezzanine Loans in Real Estate
Mezzanine loans are sometimes the only way to bridge a capital gap when purchasing or developing property. Even when they aren’t the only option, they may still be the best. Few other options increase return and preserve equity like mezzanine capital does.