Important Considerations for Mezzanine Debt
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Mezzanine loans are a popular form of subordinate financing in today's apartment finance market. Although mezzanine loans, in the case of multifamily mortgages, are not considered to be a traditional means of finance, their utility is invaluable for the right investors (both borrower and lender).
Mezzanine loans are most often used as a financial instrument to reduce the equity requirement of the borrower or investor. Traditionally, they sit in the second lien position and are a combination of both debt and equity. This equates to an increased return for the lender due to the increased risk of being in the second position and reducing the borrower's "skin in the game."
In most cases, the equity component only becomes active in the case of borrower default. It is important to note that in most cases, the rate on a mezzanine loan is a great deal higher than that of the first lien. Investors making mezzanine loans tend to look for 20%-40% returns and more. Because of this, for a borrower, these loans only make sense in very specific situations, ideally when there is a substantial "value-add" opportunity for the project in question.
While mezzanine debt greatly increases leverage, it is one of the riskiest products for lenders, so some senior lenders don’t allow it. For instance, HUD Apartment loans never permit mezzanine financing, while agency lenders like Fannie Mae and Freddie Mac usually restrict mezzanine debt to approved sources lending under specified guidelines. Conduit lenders have been known to permit mezzanine debt, but not 100% of the time. When a senior lender does agree to permit mezzanine debt, both lenders are required to sign an inter-creditor agreement, which basically governs the rules between the two parties in regards to how and when each will get paid.
In some loan transactions, particularly ones in which the borrower’s financials aren’t as strong, a lender may feel inclined to incorporate an equity kicker in exchange for reduced interest rates. An equity kicker provides the lender a small piece of equity in the property, which can be extremely lucrative if the property value takes off and the property is sold for a large profit.
In some instances, borrowers can avoid paying a portion of their interest until they actually repay their loan, by increasing the principal of the loan itself. This method is known as payment-in-kind interest or a PIK toggle. For example, a borrower with a 12% interest rate could pay 10% of their interest upfront and 2% on the back end. This back-end interest, however, is actually added to the principal and, while it will free up cash flow in the earlier portion of the repayment period, it will still increase the overall interest paid throughout the life of the loan. PIK interest is not used as often for real estate mezzanine loans and is more often used in corporate finance, though it is still utilized upon very rare occasions.
Related Questions
What are the key factors to consider when evaluating mezzanine debt for a commercial real estate project?
When evaluating mezzanine debt for a commercial real estate project, there are several key factors to consider. First, mezzanine debt can be expensive and drive up the blended debt cost. Additionally, not all lenders allow mezzanine debt, so it is important to check with the lender before pursuing this option. On the other hand, mezzanine debt can be cheaper than equity and provide higher leverage. Additionally, the interest is tax deductible. It is also important to note that some loan programs and senior lenders do not allow mezzanine debt, such as HUD multifamily loans. Additionally, agency lenders such as Fannie® Mae® and Freddie® Mac® typically restrict mezzanine debt to approved sources. CMBS lenders do permit mezzanine debt, but typically only at their discretion. In the rare event that a senior lender does agree to permit mezzanine debt, both lenders are usually required to sign an intercreditor agreement, which governs the rules between the two parties in regards to how and when each will get paid.
In some commercial real estate deals, especially ones in which a borrower’s financials aren’t as strong, a lender may incorporate an equity kicker in exchange for reduced interest rates. An equity kicker is language found in the deal contract that provides the lender with a small piece of equity in the property as incentive, which can be extremely lucrative if the real estate market takes off and the property is sold for a large profit.
Sometimes, a borrower can avoid paying part of their interest until they actually repay their loan, by increasing the principal of the loan itself. This process is known as payment-in-kind interest, more commonly called a PIK toggle. To better illustrate how a PIK toggle works, consider a borrower with a 12% interest rate who is able to pay 10% of their interest up front and 2% on the back end. With a PIK toggle, that 2% interest is added to the principal and, while it will free up cash flow in the short run, it also increases the overall interest paid throughout the life of the loan.
What are the advantages and disadvantages of mezzanine debt for a commercial real estate project?
The advantages of mezzanine debt for a commercial real estate project include:
- Cheaper than equity
- Provides higher leverage
- Interest is tax deductible
- Flexible financing
- Low probability of losing ownership or control of a property
- Does not typically require a lot of due diligence
- Increases leverage and IRR
- Flexible options include equity kickers for reduced interest rates and PIK toggles for reduced interest payments
The disadvantages of mezzanine debt for a commercial real estate project include:
- Riskier than senior debt due to lack of collateral from the borrower
- Higher interest rates, often between 10-20%
- More covenants included
- Common convenants might include restrictions on taking cash out of the property as well as a prohibition on obtaining additional financing until the mezzanine loan has been repaid
What are the most common types of mezzanine debt used in commercial real estate projects?
The most common types of mezzanine debt used in commercial real estate projects are Country club syndicates, Crowdfunding platforms, Pension funds, and Private debt funds. These lenders are available for permanent financing.
Mezzanine financing is beneficial for both first-time commercial real estate property investors, but can also be ideal for those investors who are looking to expand their property, but do not have enough funds. Mezzanine loans typically have 1-5-year terms, though some may go up to 10. In addition, many mezzanine loans are interest-only.
What are the typical terms and conditions of mezzanine debt for a commercial real estate project?
Mezzanine financing for commercial real estate typically has a minimum loan of $2 million, a term coterminous with the first lien, leverage up to 90% LTV on stabilized property and 85% LTC on construction, interest only amortization, and nonrecourse options are available. For apartment properties, the amount is typically $3 million and up, the term is coterminous with the first (typically between 5-7 years), interest rates are typically between 9% - 16%, fees are 3% - 6%, and the maximum LTC is 85%. Advantages include increasing leverage and IRR, interest being tax-deductible, and flexible options include equity kickers for reduced interest rates and PIK toggles for reduced interest payments. Disadvantages include being expensive (up to 20% for some borrowers), not allowed by all lenders, and high fees and additional legal costs. Considerations for mezzanine debt include debt being expensive and driving up blended debt cost, and not being allowed by all lenders.
What are the risks associated with mezzanine debt for a commercial real estate project?
The risks associated with mezzanine debt for a commercial real estate project include:
- Debt can be expensive and drive up blended debt cost
- Not allowed by all lenders
- Can be extremely expensive (up to 20% for some borrowers)
- High fees and additional legal costs