In a commercial real estate investment, buyers often have to look at various forms of financing to close a deal, optimize capital structure or tailor a business plan.
Usually, buyers will seek out a traditional loan from a bank first, but sometimes, that money doesn’t cover the total costs needed for a purchase. That’s where mezzanine financing comes into play.
What Is Mezzanine Financing?
The term mezzanine comes from the Latin medianus, meaning “median” or “middle.” In finance, mezzanine refers to the middle of the capital stack.
Mezzanine financing is a “hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in the case of default,” Adam Hayes wrote. If a mezzanine loan is not paid back in full during the timeline agreed upon, lenders can claim an ownership of stock or equity.
Mezzanine debt financing usually comes at a higher interest rate than traditional bank loans (sometimes around 9 to 16% for mezzanine loans, depending on the risk of the business plan) and allows lenders — in this case also known as equity investors — to potentially convert that debt into equity or stock in the case of foreclosure. This is because mezzanine capital is the highest-risk form of debt.
When Are Mezzanine Loans Used in Commercial Real Estate?
A mezzanine loan is used after a buyer takes out a traditional loan but still needs more capital to fund a purchase or capital expenditures.
While preferred equity is still a loan, it’s more of an investment in a company. A mezzanine loan, on the other hand, is structured solely as a loan with interest. In some cases, you can even get an interest-only loan.
Hayes wrote, “Companies will turn to mezzanine financing in order to fund growth projects or to help with acquisitions with short- to medium-term time horizons.”
Sammy Greenwall, Co-Founder of Lev Capital, said mezzanine loans are most commonly used when borrowers “are looking for higher leverage in the capital stack,” and when “they don’t want to give up equity.” Usually, said Greenwall, when a buyer takes out mezzanine capital, “they feel confident enough in their project that they’ll be able to pay off the lender and keep more of the upside, as opposed to just going with the typical bank loan.”
When going to a bank, a borrower needs to put in a certain amount of equity upfront. But with a mezzanine loan on top of that — although the interest is higher — a borrower can pay back the loan without losing any equity.
An Example of Mezzanine Equity Participation
Greenwall gave an example:
“If I’m going to build a bunch of apartment buildings, then it’s going to cost me $10 million. And once they’re built and there are people in them, it’s going to be worth $15 million.
If I get a bank loan, which gives me $6 million, and then I get a mezzanine loan on top of that, which gives me another $2.5 million, and I only have $1.5 million in my bank, then I basically just have to pay off the bank and pay off the mezzanine lender once I get them to the $15 million value.
And then I’ve created $5 million of equity that I get to keep myself.”
Alternatively, Greenwall said, if the borrower went with just a bank loan, the borrower would have to then raise the additional equity, sometimes through a partner or another investor. Then, once the property is worth $15 million, they would have to split the additional equity with their partner.
A mezzanine loan allows buyers to avoid seeking out partners or investors, yielding higher profit than a co-investment when all debts are paid, but more downside risk if the deal doesn’t work out.
How Are Mezzanine Loans Structured?
Mezzanine loans are equity-like and have a very specific structure when it comes to repayment, interest, and taxation. According to Fundrise, “mezzanine debt is generally structured as a loan that is secured by a lien on the property.”
If a company goes bankrupt and owes mezzanine debt, that debt can then be collected in equity or stock, or the equity investor can take over management of the property, becoming the new owner.
1. They are Subordinate to Senior Debt but Prioritized Above Common Equity in the Capital Stack
Being mezzanine, or in the middle, this type of financing is uniquely prioritized. Senior debt — usually a bank loan — is the highest priority when it comes to repayment. Mezzanine debt comes next, followed by preferred equity and common equity.
So a borrower has to first repay the bank, immediately followed by the mezzanine equity investors.
2. They Demand Higher Interest Than Standard Loans, With Less Security
As mentioned above, a mezzanine loan often has higher interest rates than standard bank loans, but the debt is less secure, meaning there is less guarantee of payment to the lender if the company loses all its assets.
This structure occurs because senior lenders have an unsubordinated first lien through the property mortgage.
3. There is No Principal Amortization
Amortization is a way to spread out loan repayment over time. In an article for Investopedia, Jason Fernando wrote, “Amortization typically refers to the process of writing down the value of either a loan or an intangible asset.”
With principal amortization, your total payments are the same each month, but “you’ll be paying off the loan’s interest and principal in different amounts,” according to The Balance.
In the case of mezzanine financing, there is no amortization, and the interest amount gets paid in full each month. In this circumstance, the entire loan amount remains outstanding throughout the loan term.
Example of Mezzanine Financing in Commercial Real Estate
If a person needs $100 million to purchase a commercial real estate property, and the bank is willing to loan $80 million, then the buyer still needs $20 million. Let’s say a buyer has $10 million in capital that they are willing to put into the purchase. Now, they need $10 million more, which often leads a buyer to seek out a mezzanine loan to cover that additional cost.
Advantages of Mezzanine Funds
Mezzanine financing can prove beneficial to both lenders and buyers, but for different reasons.
In the Case of Foreclosure, Lenders Can Still Gain Equity
Although this is never the goal of mezzanine financing, if a borrower is unable to repay their debts, lenders are in a position to gain equity or stock in a company, or become full owners. That way lenders don’t entirely lose out in the case of foreclosure.
If a deal goes badly and the buyer loses money, “the mezzanine lender can then sell the property,” Greenwall said. “If I’m a mezzanine lender, and you haven’t paid me back, or you’ve broken the contract, or you haven’t completed the project, I have the power to foreclose on a project.”
In the case of foreclosure, the bank gets its money first, followed by the mezzanine lender.
As a Lender, You Can Earn High Interest Rates
With such high interest rates, lenders are also in a position to profit quite a bit over the course of the loan term. The interest is contractually obligated and, according to Hayes, could be paid “monthly, quarterly, or annually,” depending on the terms of payment.
Mezzanine Debt is Flexible and Tax-Deductible
Buyers can deduct interest associated with their loan from their taxable income, but payments can also be deferred in a way that other loans do not allow for.
Hayes wrote, “mezzanine financing is more manageable than other debt structures because borrowers may figure their interest in the balance of the loan. If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred,” depending on the terms of the contract.
Buyers Are Able to Retain More Equity
If all debts are paid on time, a mezzanine loan allows a buyer to avoid seeking out common or joint venture equity in the form of a partner or investor. Therefore, whatever profit is incurred could go to the buyer alone, rather than splitting profits with a joint venture investor.
Disadvantages of Mezzanine Financing
On the other hand, there is a bit of risk when it comes to mezzanine financing, again for both mezzanine investors and borrowers.
Owners Risk Losing Stake and Control
Because lenders can convert mezzanine debt into equity or foreclose on a property entirely in the case of default payment, owners risk losing stake and control of their company.
In some situations, depending on how much a borrower owes, a lender could gain a controlling share, or lose their company altogether, if company finances take a dip.
Buyers Pay Greater Interest
For a lender, the high interest rates are one of the great advantages of mezzanine financing. This is not the case for buyers, who are paying significantly higher rates than they would a bank or traditional lender.
According to Investopedia, “Owners also pay more in interest the longer mezzanine financing is in place.”
Lenders Risk Losing Their Investment
As is the case with any real estate investment, there is always a risk of losing everything. For lenders, they risk losing their investment if a company goes out of business. Although lenders can potentially earn equity if a borrower defaults on payment, there’s always a chance there is no equity to earn at all.
Hayes wrote, “when a company goes out of business, the senior debt holders get paid first by liquidating the company’s assets. If there are no assets remaining after the senior debt gets paid off, mezzanine lenders lose out.”
The bottom line is, if there’s no money to pay off the debt, and no company to gain equity in, then mezzanine lenders don’t get paid.
Mezzanine Financing Is a Way for Borrowers to Gain the Extra Capital Needed to Close a Deal, With Some Caveats
Mezzanine financing can be extremely beneficial when trying to purchase a commercial real estate property. However, there are a few important factors to remember, such as the high interest rates and the potential for converting debt into equity down the line.
According to Greenwall, the most important idea to keep in mind is, “in a very basic sense, [mezzanine loans] allow you to fill up the capital stack at a higher leverage. You get higher leverage on your deals, but you also have to pay more for it. And it makes the deal more risky because if you don’t get your returns, you can get into a lot of trouble.”
Before making any major decisions, it’s best to talk to a financial advisor to figure out which options are best for you and your real estate deal.
Mezzanine Financing FAQs
Mezzanine financing can help commercial investors and developers bridge the gap between their senior debt, often a traditional mortgage, and their equity share. A mezzanine lender can help you gain additional leverage.
The term mezzanine comes from the Latin for “middle” because it is usually subordinated debt. Mezzanine debt sits in the middle of the capital stack, subordinate to senior debt and below preferred equity and common equity.