In commercial real estate, mezzanine loans allow borrowers to make up the difference between their equity investment and the senior debt provided by lenders like a bank or credit union.
Mezzanine financing gets its name from the “mezzanine” of a building—the floor right above the ground floor.
Similarly, mezzanine financing is a form of subordinated debt that rests on a “floor” above the higher priority senior debt in the capital stack.
Although mezzanine financing often comes with a higher interest rate, it can enable a higher rate of return for the borrower.
In this article, we’ll explore the key features, pros and cons, use cases, and alternatives to mezzanine loans.
Let’s dive in.
Key Features of Mezzanine Loans
A mezzanine loan is an additional debt taken on by the borrower to finance a commercial real estate acquisition or expansion project. Mezzanine loans reduce the amount of equity that borrowers need to commit in order to purchase a building or property.
Mezzanine financing usually comes with certain specific characteristics:
- Mezzanine financing is subordinate to senior debt, but it has priority over preferred and common equity. In the case of bankruptcy, this capital structure determines which creditors get paid first.
- Mezzanine financing typically comes with a higher interest rate than senior debt.
- Mezzanine financing is typically not secured by collateral.
- Mezzanine financing is structured as interest-only, as opposed to amortizing the principal over the life of the loan.
- Mezzanine financing often lasts for a shorter duration than secured debt.
These core features of mezzanine loans set it apart from other commercial real estate financing options.
Pros of Mezzanine Loans
Mezzanine loans can be a great way to finance your commercial real estate purchase.
We’ll describe some of the top 3 benefits below.
Complete your financing
Mezzanine loans can be a great way to bridge the gap between your secured debt and the final cost of your commercial property.
Consider the following example:
Say you want to purchase a property that costs $10,000,000.
You secured 60% of the cost of the property through a bank loan. That means you still need to come up with 40% of the final cost of the property.
The problem? You might not have the cash to front $4,000,000. If that’s the case, you could split that cost between equity and mezzanine debt.
Specifically, you could sink $2,500,000 of your own equity into the property and take out a mezzanine loan to cover the last 15% ($1,500,000) of the property price.
In similar situations, both individuals and companies rely on mezzanine financing to bridge that final gap between secured debt, equity, and the property’s cost.
Reduce your equity requirement
Even if you do have the capital to avoid taking out a mezzanine loan, you might still want to take one out.
So you can keep your capital free.
For instance, you might be closing multiple real estate deals at the same time, and you might not be able to afford to sink a high amount of equity into one of the projects.
In that case, a mezzanine loan would be a great solution to complete the deal.
Pursue flexible financing
Mezzanine loans provide a flexible financing option for borrowers and investors who want to keep their capital free, or who don’t possess the financial liquidity to sink a huge amount of cash into their property.
Mezzanine loans typically require less due diligence than other loans from banks and credit unions.
That means they often close quickly, often within a period of 10-15 business days.
Cons of Mezzanine Loans
Despite their multiple benefits, mezzanine loans aren’t without their drawbacks.
Because the borrower doesn’t need to post collateral, mezzanine loans present a higher risk to lenders than the risks presented by senior debt.
That risk leads to higher interest rates—often between 10-20%—and the presence of more covenants.
Covenants might include restrictions on taking equity out of the property or prohibitions on obtaining additional financing until the entire mezzanine loan has been repaid.
Mezzanine commercial real estate loans also include prepayment penalties if borrowers attempt to pay off their loans early.
Because these prepayment penalties are often expensive, they’re something to watch out for before finalizing mezzanine financing.
Mezzanine Loan Use Cases
Mezzanine loans are most often used for the acquisition or refinance of an investment property.
They can be a great option for first-time commercial real estate investors.
Additionally, mezzanine loans can also be a quality option for borrowers looking to expand their holdings without a large amount of cash on hand.
Whether you’re an experienced investor or just dipping your feet into the commercial real estate world, mezzanine loans are a great option for closing the gap to finance your property, in addition to a loan from an initial lender or bank.
Mezzanine loans let you avoid drawing on your savings or capital to close your deal.
Although interest rates are high, mezzanine financing allows you to keep your capital free and empties a minimal amount of money from your pocket.
Mezzanine Loan Requirements
Below are some of the fundamental requirements for mezzanine loans.
- Minimum Loan Amount: $2MM
- Term: continuous with the first lien, typically 1-5 year terms, and sometimes up to 10 years
- Leverage: Up to 90% LTV on stabilized property. 85% LTC on construction properties
- Amortization: interest-only
- Recourse: Non-recourse options available
Mezzanine Loan Rates
Check out the table below for a description of mezzanine loan rates for 5, 7, and 10-year loan terms.
|Term||Fixed-Rate||Floating Rate||Max LTV||Max Amortization|
|5 years||5.24% – 8.24%||N/A||75% – Investment||30 years|
|7 years||5.91% – 8.91%||N/A||75% – Investment||30 years|
|10 years||6.56% – 9.56%||N/A||75% – Investment||30 years|
Mezzanine Loan Costs
Mezzanine loans are more expensive than mortgage debt; however, they are much less expensive than equity.
Some mezzanine interest loans come with interest rates up to 20%. Additionally, they can oftentimes present higher fees and legal costs.
Although taking on mezzanine debt can greatly increase your leverage, it’s important to know what this debt might cost you.
Below is a sample mezzanine financing loan term sheet for a commercial property loan.
Sample Mezzanine Financing Term Sheet for Commercial Real Estate Property
- Amount: $3M and up
- Term: Coterminous with the first (5-10 years)
- Interest Rate: 9-16% (interest only)
- Fees: 3-6%
- Maximum LTC: 85%
Alternatives to Mezzanine Loans
Preferred equity is a common alternative to mezzanine loans.
For commercial real estate borrowers or developers in need of more funds, preferred equity can be a great financing option.
Mezzanine financing represents debt with an equity conversion option; conversely, preferred equity lets the outside investor direct equity into the project itself.
This gives that outside investor a fixed rate of return.
Additionally, unlike mezzanine debt, preferred equity investors do not possess a lien against the entity holding the property. Unlike first position lenders, they do not hold a lien against the property.
Not possessing a lien against the property makes preferred equity a riskier option for a lender.
However, many lenders who pursue the preferred equity option often receive an “equity kicker”—an additional equity incentive that lets them participate in the project’s upside if it passes a certain financial milestone.
Is mezzanine financing right for you?
Before committing to any type of financing or debt, it’s important to get a full picture of your financial situation and identify all your options.
When you’re ready to commit, Loanbase has everything you need to make the financing process easy and pain-free.
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