In real estate, there are many different options when it comes to financing a deal. Mezzanine debt is a lending option that offers investors with unique benefits. We’ve seen investors use it to close funding gaps, maximize opportunities, and scale their portfolio to heights that wouldn’t have been feasible with other types of funding.
As mentioned in a Multifamily Executive article, “the need for mezzanine financing is particularly acute in the nation’s secondary and tertiary markets.” v
But what exactly is mezzanine debt, what are the benefits, and more importantly, risks, associated?
We’re diving into all of this and more below.
What is Mezzanine Debt?
Mezzanine funding is commonly employed when a traditional lender doesn’t cover the full amount of financing needed to get a deal across the finish line. In return for providing the needed capital, these “investors” receive interest on their money, and sometimes, even equity in the company or the deal.
Mezzanine debt usually has features of both debt and equity, making it a sort of hybrid type of loan.
Mezzanine Debt Structure
Within the capital stack of a deal, you’ll typically find mezzanine debt below the senior debt. This means that if bankruptcy or a default occurs, the senior debt holders are the first ones to get paid back. So senior debt investors are in first position, above mezzanine debt, which means mezzanine debt holders take on higher risk than their senior debt counterparts. But, they’re still taking on less risk than equity partners, who sit below mezzanine debt in the capital stack in the repayment priority order. See the example below for a visual representation of what I’m describing.
But because of this higher level of risk, mezzanine debt holders will typically charge a higher interest rate than senior debt holders do, and their repayment timeline is usually longer. A typical mezzanine interest rate might fall between “ 9-11%.” It’s not uncommon for mezzanine debt to involve some kind of equity-flavored strings attached, such as options to convert their debt position into equity.
The exit plan for mezzanine debt is also predetermined in many cases. This allows them to have multiple plans to ensure their position is secured. For example, they may plan to have their investment be repaid through senior debt refinancing, or from cash flow, or upon the sale of the asset.
The Devil’s In The Differences: Equity vs Mezzanine
Equity reflects an investor's ownership in a real estate deal, and they receive distributions, cash flow, and tax benefits proportionate to their ownership stake. Equity capital investments usually go towards the long term needs of a real estate asset, such as renovation and capital expenditures, debt servicing, and value-add projects. Mezzanine loans are usually used to close a financing gap, help close a deal, or take on specific projects that demand large capital injections.
Mezzanine debt is prioritized over common equity and preferred equity investors in the capital stack. But it’s still placed behind the senior debt. To cover their risk exposure, mezzanine debt providers will have some kind of right to equity instruments or take control of the property, contingent on the terms outlined in the agreement.
Fun fact: Mezzanine debt gets its name from the word “mezzanine” which means “a low story between two others in a building, typically between the ground and first floors.”
Source: Property Metrics
Pros of Mezzanine Debt
Mezzanine debt providers reap multiple benefits.
Possibility of Higher Returns: Since mezzanine lenders usually take on higher levels of risk compared to senior debt, they can demand higher interest rates, and thus, receive more of a return on their investment.
Distributed Risk: By diversifying among different assets in different markets and asset classes, mezzanine lenders can spread their risk.
Cash Flow: Mezzanine debt providers receive consistent interest payments on the loan they made to a given real estate deal.
Equity Advantage: Mezzanine debt providers have the option to get in on the benefits of being an equity investor in a deal. So, if the property appreciates in value, they can also ride this wave and reap the fruits of appreciation.
Flexibility: Mezzanine debt is usually more flexible, offering fluid interest rates, repayment plans, and negotiable terms that can make them a more attractive financing option over traditional debt providers.
Pros To Investors and Sponsors
No Equity Dilution: Mezzanine loans give investors access to needed capital without the pains of diluting equity by raising more common or preferred equity.
Interest Payments Are Tax-Deductible: Payments made on interest for a mezzanine loan are usually able to be written off on taxes. Though, you should consult your tax advisor for more information, as each situation is unique.
Mind Your Risk With Mezzanine Debt
While there are many benefits to using or providing mezzanine debt, there are risks to be aware of. If you don’t take risks, you can’t make a profit, but still - here are some things you should consider.
No Collateral: Most types of traditional debt is secured, meaning the lender can go after a certain asset if the subject property defaults. But mezzanine debt usually depends more heavily on the borrower’s credit history and cash flow. This obviously exposes the mezzanine debt holder to more risk. Recovering outstanding balances can be a beast for mezzanine debt providers.
Complexity Curve: As we mentioned earlier, mezzanine debt can involve hybrid features - both from equity and debt. This makes it more difficult to understand and structure, and the negotiation process can be more challenging as a result because it’s not as clear what the risks are.
Illiquid: Mezzanine debt, from the lender’s perspective, is not as liquid, and therefore, it can be challenging to exit before the loan matures. This means that mezzanine debt providers should expect to be in the deal for the long haul.
For investors, mezzanine debt can be expensive, with rates as high as 20%. It’s also not allowed by some senior debt providers. Bringing on mezzanine debt can also involve expensive legal fees to structure.
Big Picture On Mezzanine Debt
The underwriting process continues to be rigorous, placing more of an emphasis on the borrower than the real estate property itself. This is especially true in today’s volatile, and uncertain environment.
But mezzanine debt investments continues to provide institutional investors with opportunities, as explained by M. Jason Mattox, COO of Behringer Harvard Holdings. “Mezz debt investments also can enable investors to participate in a broader range of opportunities at a more attractive basis than other investment options.”
What has your experience been with mezzanine debt- as a provider or a borrower? Would you use it again? Please let us know down below!