Mezzanine Financing. Understand the Basics.
If you’ve been in the commercial real estate business long enough, you will understand that there are often financing shortfalls. How do developers fill the gap between available equity, and the primary mortgage? A number of options are available, including securing investors and partners. There are times however, when the gap is just too large. That’s when developers will turn to Mezzanine Financing.
A hybrid of debt and equity
Mezzanine financing (a.k.a. a Mezz loan) is technically a hybrid of debt and equity. It provides the lender the opportunity to convert their debt into an ownership or equity position, in the event of borrower default, after senior debt holders are paid.
In the commercial real estate marketplace, a Mezz loan has come to describe any financing that bridges the gap between the owner’s equity and the 1st mortgage. Since Mezz loans are typically junior in priority and subordinate to the primary mortgage, mezz loans typically carry a higher interest rate. Why? Simply put its a considerably riskier position for the lender. The pricing reflects that additional risk.
Lets consider an example
Mezz loans are not uncommon in real estate development. As an example, institutional lender’s may be less inclined to offer a full loan (75% to 80%) of costs in a new condo construction situation, particularly in an environment where there are concerns with overbuilding, or excess supply of product. Perhaps they will only lend 65% of costs. A developer may only have 15% equity, and the 20% shortfall is therefore typically financed by a Mezzanine lender. Here’s what it would look like:
Debt or Equity
As discussed, Mezz loans can be structured as debt or equity. If a debt transaction, the Mezz lender usually takes a collateral 2nd Charge position, if the 1st mortgagee permits it. Alternatively, and quite common, is security via an Assignment of Partnership Interest. If there is an event of default, the Mezz lender steps into the shoes of the borrower and effectively becomes the equity owner. Such an arrangement typically requires an Intercreditor Agreement. Equity transactions are not dissimilar. They often take the form of Partnership Agreements, which provide the Mezz lender with major decision making authority. Default in these situations typically enable the Mezz lender to take control of the borrower’s position, but not the property itself. The devil is in the detail, and each loan agreement is unique.
What are the benefits?
Mezz lenders provide much needed cash, but at a price. Not only is debt more expensive, but owners may lose flexibility and control, and upside (profit) potential. However, developers will not have to inject as much cash, and there is a potential (though likely unplanned) project partner, inasmuch as the Mezz lender may step in to protect their interest should the project begin to falter.
Primary (1st mortgage) lenders have differing views on the role and benefits of Mezz debt. However, an experienced Mezz lender can bring stability to a project. They will typically protect their interest, and not allow the 1st mortgagee to take legal action should a property falter.
The Intercreditor Agreement is the operative instrument in Mezz financing. Seek competent legal advice when considering the appropriateness of such a financing structure, and determine early on, what your primary lender’s position is, with respect to a Mezz lender subordinate to their position.