Understanding Mezzanine Loans
Mezzanine Financing
Mezzanine financing is a go to for investors who want to maximize IRR while maintaining maximum leverage. Mezzanine loans — a blend of debt and equity financing — are a unique kind of financing vehicle that allows lenders the right to convert the debt into equity interest in the owner company in the event of default. Many investors find these loans to be ideal for recapitalization or refinancing if the current debt is higher than what can be obtained through conventional lenders.
Despite the usefulness of mezzanine financing, it often is subject to restrictions — if allowed at all. HUD loans, for example, do not permit mezzanine financing. Other agency programs such as those offered by Fannie Mae or Freddie Mac only allow mezzanine debt from approved sources. Securing mezzanine debt with a CMBS lender can be hit or miss as well.
Despite the restrictions, mezzanine financing remains a popular option for apartment investors. The purpose of this guide is to highlight the ins and outs of mezzanine financing, and the reasons for its use.
What Is a Mezzanine Loan?
A mezzanine loan is a special method of financing that is a blend between debt and equity financing. Mezzanine loans provide a buffer between senior debt and the investor’s equity, allowing lenders to go higher on the capital stack than typical debt would allow. Structurally speaking, this debt is unique in that it comes with an equity conversion option. Basically, in the event of a default, it allows lenders the right to seize a “portion” of the investment property and sell it in order to recoup losses.
Mezzanine loans typically have one- to five-year terms, though some lenders allow up to 10 years. Typically, mezzanine loans have a maximum LTC of around 85%. Beyond that, mezzanine loans can be pretty flexible depending on the lender. Investors might be pleased to know that interest charged on mezzanine financing is tax deductible, and many of these loans are interest only.
Mezzanine Financing vs. Preferred Equity
Mezzanine loans are often confused with [preferred equity](). Preferred equity — unlike mezzanine financing which simply grants the option to convert — grants the lender direct equity in the project itself. Preferred equity can be a popular option for outside investors, since it typically represents a fixed rate of return.
That said, preferred equity lenders do not possess a lien against the entity that holds the property, nor do they have a lien against the property as a first position lender would. This makes a preferred equity investment substantially riskier than a mezzanine loan. Still, many preferred equity transactions include an “equity kicker”, which is an incentive that allows them to participate in a project providing it has cleared a specific financial hurdle.
Mezzanine Financing, Agency Lenders, and Intercreditor Agreements
While HUD remains opposed to mezzanine financing, some agency lenders, such as Freddie Mac, have introduced mezzanine (or mezzanine-adjacent) financing products in order to help encourage borrowers to keep properties affordable. Freddie Mac’s targeted affordable housing mezzanine loan, for example, is originated at the same time as the 10-year Freddie Mac TAH Loan in one streamlined process, creating a combined maximum LTV allowance of up to 90% and a combined minimum DSCR of 1.05x — figures that many investors find desirable. While Fannie Mae does not have its own mezzanine loan program, it does allow borrowers to utilize mezzanine debt in a variety of situations.
Because there is substantially more red tape involved with agency lending, this usually necessitates the signing of an intercreditor agreement. This agreement must be signed by both the primary lender and the mezzanine lender in order to establish the borrower’s order of repayment, ensuring everyone gets repaid fairly. Intercreditor agreements also define each lender’s rights and responsibilities involving their shared relationship with the borrower.
Most apartment lenders require collateral property to be held by a bankruptcy-remote special purpose entity (SPE), but this is an even bigger concern for mezzanine lenders, who want to ensure that they will be paid back in any event — even bankruptcy. Generally, an intercreditor agreement includes language pledging the mezzanine lender 100% of the shares of SPE as collateral. In fact, in some cases, the special purpose entity is made to have an independent director, in order to further reduce the chance of the borrower trying to file for bankruptcy.
Benefits of Mezzanine Debt
- Higher leverage and IRR than standard offerings
- Interest is tax deductible
- Highly flexible
- Faster to close
- Ownership of property not at risk
- Higher interest rates
- Typically includes lender-friendly covenants
- Not allowed or heavily restricted by agency lenders
- High fees and additional legal costs
- Lenders are granted a lien against the borrowing entity
What is a mezzanine loan?
A mezzanine loan is a special method of financing that is a blend between debt and equity financing. Mezzanine loans provide a buffer between senior debt and the investor’s equity, allowing lenders to go higher on the capital stack than typical debt would allow. Structurally speaking, this debt is unique in that it comes with an equity conversion option. Basically, in the event of a default, it allows lenders the right to seize a “portion” of the investment property and sell it in order to recoup losses.
Mezzanine loans typically have one- to five-year terms, though some lenders allow up to 10 years. Typically, mezzanine loans have a maximum Loan to Cost Ratio of around 85%. Beyond that, mezzanine loans can be pretty flexible depending on the lender. Investors might be pleased to know that interest charged on mezzanine financing is tax deductible, and many of these loans are interest only.
Mezzanine loans have become a popular form of secondary, or subordinate financing in today's commercial real estate market. Although mezzanine loans, in the case of commercial mortgages, are not considered a traditional means of finance, their utility is undeniable, and for the right investors (both borrower and lender), mezzanine loans are an invaluable tool.
Mezzanine loans are most often used as a finance instrument to reduce the equity requirement of the borrower or property owner. Traditionally they sit in the second lien position and are a hybrid of both debt and equity. This means increased return for the lender, obviously due to the increased risk, of being in second position and reducing the borrower's "skin in the game."
In most cases the equity component only kicks in, in the case of borrower default (and, in most cases, the rate on a mezzanine loan is a good bit higher than that of the first lien). Investors making mezzanine loans may look for 20%-40% returns and more. Because of this, for a borrower, these loans only make sense in very particular situations, ideally where there is a substantial "value-add" opportunity in the project in question.
Since CMBS loans typically prohibit second mortgages, many borrowers have turned to mezzanine financing to fill in the gap. Mezzanine financing, unlike a traditional second mortgage, is a hybrid of debt and equity that permits the lender to convert their debt into shares in the borrower’s company in the case of a loan default. Therefore, the mezzanine lender sits between the CMBS lender and the equity shareholders in terms of repayment priority, and is junior to the CMBS lender’s claim on the company’s assets.
What are the advantages of a mezzanine loan?
What are the disadvantages of a mezzanine loan?
The disadvantages of a mezzanine loan include:
- Can be extremely expensive (up to 20% for some borrowers)
- Not allowed by all lenders
- High fees and additional legal costs
- Higher interest rates
- Typically includes lender-friendly covenants
- Not allowed or heavily restricted by agency lenders
- Lenders are granted a lien against the borrowing entity
What are the eligibility requirements for a mezzanine loan?
Mezzanine loans typically require a minimum loan of $2 million and leverage of up to 90% LTV on stabilized property and 85% LTC on construction. Amortization is usually interest only and nonrecourse options are available. When layering a second debt piece on top of a lower leverage senior loan, some conduit lenders allow this, while others do not. The addition of a second-position loan on top of CMBS senior debt often requires creative structuring, additional legal fees, and the use of an intercreditor agreement between the two lenders.
What are the typical terms of a mezzanine loan?
Mezzanine loans typically have one- to five-year terms, though some lenders allow up to 10 years. Typically, mezzanine loans have a maximum Loan to Cost Ratio (LTC) of around 85%. Beyond that, mezzanine loans can be pretty flexible depending on the lender. Investors might be pleased to know that interest charged on mezzanine financing is tax deductible, and many of these loans are interest only.
Sample Mezzanine Loan Terms for Multifamily and Commercial Property Loans in 2023:
Amount Term Interest Rates Fees Maximum LTC $3 million and up Coterminous with first (typically between 5-7 years) Typically between 9% - 16% (interest-only) 3% - 6% 85%