So you’re looking to become an investor in commercial real estate? Well, you’re going to need some resources to do so.
The different sources that go into financing a commercial real estate project comprise what’s called ‘the capital stack’. One of the components that make up the capital stack is mezzanine debt.
What Is Mezzanine Debt?
When it comes to large commercial real estate deals, sometimes buyers need more capital than a traditional lender is willing or able to offer. That’s where mezzanine loans come in. How does mezzanine financing work, you ask?
Sammy Greenwall, Co-Founder and Chief Strategy Officer at Lev, broke it down for us:
Meet Bob. Bob is planning on becoming a sponsor, also called a general partner, for a multi-family apartment building. As a sponsor, Bob is in charge of finding, acquiring and managing the property. He is also expected to invest 10% of his own money.
Bob reaches out to a bank that is willing to make a 60% investment into the project. Bob is still missing 30% of the required amount to make the deal.
Bob finds a lender who can make up the remaining investment in the form of mezzanine debt.
This dynamic may seem simple enough, but mezzanine debt comes with its pros and cons, and it can be riskier than other forms of debt and equity.
How Does Mezzanine Debt Fit Into the Capital Stack?
Simply put, the capital stack is the different sources of capital that make up the total capitalization of a commercial real estate deal. While you certainly don’t need a mezzanine loan to move forward with a commercial real estate deal, it can be used to fill out the capital stack as an alternative to using preferred or common equity.
How exactly does mezzanine debt fit into the capital stack? Let’s break it down.
You can envision the capital stack like a building. At the base of the building is senior debt, which is provided by a traditional senior lender like a bank. Just above that is mezzanine, followed by preferred equity, with common equity at the very top.
Mezzanine is derived from the Latin for “middle,” so being above senior debt and below preferred equity makes sense.
Mezzanine Debt vs Preferred Equity: What’s the Difference?
Preferred equity and mezzanine debt are sandwiched right in the middle of the capital stack above senior debt. So what’s the difference between them?
A borrower or sponsor can use both mezzanine financing and preferred equity to gain higher leverage at a lower cost than common equity. The main difference between mezzanine debt and preferred equity is just that — one is debt, and one is equity.
Mezzanine debt is typically structured like a loan (which is why it is also called mezzanine financing) as a direct investment in the property but offers an indirect pledge of equity if the borrower defaults on the senior debt. The collateral for mezzanine financing is a pledge of equity in the entity.
Preferred equity gives investors an equity investment in the property. This is secured via terms, rights and remedies, and controls outlined in the investment’s operating agreement.
Practically speaking, mezzanine debt and preferred equity often function with similar terms and conditions.
Benefits of Mezzanine Financing
Now that you’re familiar with mezzanine debt and its role in the capital stack, you’re probably wondering what benefits it offers.
Gives Buyers Access to Larger Deal
Most senior lenders will not provide all the required capital a borrower needs to purchase a property. If they are not able to make up the difference with their own cash, they will need to turn to other forms of financing, such as debt financing.
Mezzanine loans give enough money for buyers to invest in larger deals they might not have otherwise been able to access.
The Interest is Tax Deductible
Mezzanine financing typically comes with higher interest rates than senior debt in return for the risk involved. Luckily for borrowers, the interest payments are usually tax-deductible.
Borrowers are also able to retain all of the deal’s tax benefits in terms of depreciation, rather than sharing it with investors.
Borrowers Retain Upside
When borrowers use equity as a way to cushion investments, they typically lose out on some upside or the increased property value after their initial investment.
With mezzanine financing, the borrowers only have to pay mezzanine lenders the amount borrowed plus any interest accrued. Investors can also perform leveraged buyouts if the partnership agreement allows for them.
Different Repayment Options
The structure of mezzanine loans vary, and lenders often allow different forms of repayment, including providing equity to the lender, adding interest to the loan balance or making interest payments with cash.
Helps with Capital Structure
Mezzanine debt sometimes appears as equity on a borrower’s balance sheet. This labeling can make it appear like they have lower debt levels, which can make it easier for them to access other types of financing.
Disadvantages of Mezzanine Debt
Whether you’re the borrower or the lender, commercial real estate always comes with risk. Here are some disadvantages of mezzanine debt:
Possible Equity Loss
Although mezzanine debt can give more leverage than a borrower may have otherwise had, it also comes with the possibility of substantial debts and loss in equity if they don’t end up making money on the property. A mezzanine loaner’s collateral is the owner’s equity. In addition to the loss of equity, an owner will also lose out on the money they personally invested if they don’t hit their return.
Lenders Have More Control
Mezzanine lenders may be able to set specific criteria that borrowers have to abide by such as limits on financial ratios and a specific payback period.
Because of the riskier nature of the mezzanine loan, it can also come with substantially high interest rates. This aspect can be a pro or a con depending on whether you’re the borrower or lender.
Again, this interest rate is often tax deductible for the borrower.
Lower Seniority on The Capital Stack
For mezzanine lenders, their position on the capital stack means they are at greater risk of losing money due to default.
In the case of bankruptcy, senior lenders like a bank will be repaid before a mezzanine lender.
Mezzanine Debt FAQs
Hopefully, by now you understand the basics of how mezzanine debt fits in the capital stack, but you still may be left with some questions.
What is Mezzanine Equity?
Mezzanine equity is not a correct term. Let’s clear up some of the confusion.
Although equity may be part of a mezzanine financing deal, mezzanine is still a form of debt financing, making mezzanine debt the correct term.
Mezzanine debt and preferred equity however, are very similarly structured, and are sometimes used interchangeably.
Do I Need a Mezzanine Lender?
No, you do not need a mezzanine lender to invest in commercial real estate. Although it can give you more leverage, it also comes with substantial risk.
How Do Mezzanine Funds Make Money?
Mezzanine funds make money from the high-interest amounts paid by a borrower. They may magnify their returns through selling off a piece of their investment at a lower interest rate than they originated or by internally financing themselves at the loan or fund level.
How Do I Invest in Mezzanine Debt?
People typically invest in mezzanine debt either by negotiating directly with the borrower or by investing in a pooled private fund that focuses on mezzanine debt investments.
Mezzanine Debt and The Capital Stack: Bottom Line
Although mezzanine debt isn’t necessary for a borrower to proceed with a commercial real estate deal, it can offer more leverage and the possibility of a higher return.
When it comes to the capital structure, mezzanine debt is subordinate to senior debt. Because mezzanine debtors have a higher risk of losing money, they charge high interest rates and collateral in the form of equity.
You can think of mezzanine debt as an extra cushion that comes with high risk, yet the potential for high reward for both borrowers and lenders.