“What is mezzanine financing, anyway?”
This financing vehicle is becoming extremely popular, but what exactly is it?
As more money flows into real estate related investments, the emergence of new, innovative financing products follows. In residential lending, we’ve seen products such as pay-option ARMs become widely used, as lenders find more outlets for these loans on the secondary markets. In the commercial real estate markets, mezzanine financing has recently become a hot topic. So what exactly is mezzanine financing, anyway?
This question has one answer, with multiple meanings. To begin, we must look at the characteristics that make up a mezzanine financing. By definition, a mezzanine loan is a hybrid of debt and equity, generally subordinate to any senior debt. Given its subordinate position, the lender usually receives a much higher coupon rate than what would be 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.
So how can mezzanine financing benefit your business? Given the continuing tightening of the banks and senior lenders with respect to their LTV’s, borrowers are being forced to put more capital into projects than they originally anticipated. Many commercial borrowers, including developers and individual investors, are looking to use as much leverage as possible, keeping them liquid and, hopefully, maximizing returns. However, depending on the type of project the borrower is getting into, high leverage may not always be the best way to structure the deal, as it may cause negative cash flow or eat up most, if not all, of the potential profits.
Common mezzanine structures and terms
Although by its very nature, mezzanine financing has no set terms or structures, there are few types of deal terms that are most commonly used in real estate transactions. These include the following:
Straight debt instrument
This is the most common type used in stabilized properties, and is also the easiest to understand. The mezzanine lender will be in a subordinate, or junior, lien position, usually to a CLTV of up to 85%. In this scenario, the lender has no equity participation in the project’s cash flow, nor does it have any say in the management of the project. Depending on the CLTV, type of project and strength of the borrower, yields typically fall within the 9-13% range, with terms matching those of the senior note.
Participation note
When borrowers are looking for higher leverage and are willing to give up some of the cash flow or equity for it, mezzanine lenders can structure the loan as a participating debt instrument, which is a debt/equity hybrid of sorts. By doing this, borrowers can usually get up to 90% CLTV, but give up some of the upside potential of a good project. The mezzanine lender will usually receive a slightly lower coupon rate on the note, but will potentially increase its overall IRR by participating in the project’s cash flow or receiving an exit fee when the project sells. However, given the increased risk the lender is assuming via the higher LTV, a greater yield is required. This is considered when calculating the coupon rate and percentage of equity the mezzanine lender will request from the borrower. On a standard, stabilized transaction, the mezzanine lender will look for a 15-18% overall IRR, but may require a higher return for transactions they deem “riskier.”
Preferred equity
One step shy of a pure equity play, the preferred equity structure gives the mezzanine lender some control over the project, along with a greater equity position than that of a participating note. The borrower and lender usually enter into a partnership or joint venture agreement, which defines the role each party will play, the equity ownership of each and any other terms of the transaction. Although many borrowers do not like giving up control of their project, most are willing to in exchange for not having to commit substantial capital to the project, which is why many enter into this type of agreement to begin with. On the other side of the equation, the mezzanine lender enjoys more control, a higher overall yield and the ability to step in and take over the property in the event of default. This is in exchange for the lender assuming a greater amount of risk due to the high CLTV and the borrower’s limited amount of capital at risk.
Uses for mezzanine financing
As you can imagine, mezzanine financing can be applied to many situations. Once used almost exclusively for corporate finance deals, investors have found many uses for mezzanine financing in real estate. Stabilized properties, value-add and new development are the three main types of transactions, each having its own unique characteristics, where mezzanine financing can be utilized. Although the level of complexity will vary from one transaction to the next, it should be assumed that the more moving parts a transaction has, the more difficult it becomes to structure the capital stack to include the use of mezzanine financing.
Stabilized properties
In the case of stabilized properties, the mezzanine piece is usually a straight debt instrument, subordinate to the senior note, with no equity component. This is the most common and straightforward type of mezzanine financing being used in real estate at this time, as it contains the least amount of risk and is the easiest for borrowers and lenders to understand. For stabilized properties, mezzanine financing will only work if the property generates enough cash flow to cover the debt service of both the first mortgage and the mezzanine piece, along with the operating expenses, and still provide the owner with a return. If it does not, the use of mezzanine financing is probably not appropriate.
Value-add
Value-add, or non-stabilized properties, are those properties where cash flow is not stabilized. This could be for any number of reasons, but for this article, let’s assume it’s because the property requires significant improvements in order to attract new tenants and increase lease rates. A borrower that has identified a potential opportunity to reposition a property would look to a mezzanine lender for the capital, in excess of what the senior lender will commit, needed for them to execute their plan to create value.
Given the dependency on the borrower to successfully complete the repositioning in order for the project to work, the mezzanine lender will closely look at the borrower’s and/or the project manager’s resumes when underwriting the deal. Therefore, it is extremely important for both (if the borrower is not the project manager) to have experience and expertise in value-add investments.
Developments
Considered the riskiest of the three transaction types discussed in this article, development deals are the most challenging to structure and require the most due diligence on the lender’s part. Since developers, by nature, like to employ the use of heavy leverage on their projects, mezzanine financing is often a key component of the capital stack. More often in development deals, as compared to stabilized properties, mezzanine financing takes the form of preferred equity rather than straight debt. This is due to two main factors: the lender’s need to achieve a higher IRR because of the risk; and the lender wanting the ability to participate in the decision making process and management of the project. Again, because development projects contain the most risk and uncertainty, the lender wants to do whatever it can to protect its investment.
Summary
As you can see, mezzanine financing plays a big role in commercial real estate deals and can be a valuable tool for investors and developers. This means that it should be a product you are familiar with and one that you are comfortable telling your potential clients about. Remember, as more residential loan officers make the move to commercial, the way to stay one step ahead is to educate yourself, learn as much as you can and continue to grow as a professional.
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