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Mezzanine Financing for Apartment Properties
Merchant builders who aim to maximize their IRR also need to maximize leverage, as the cost of equity is oftentimes more expensive than non-recourse debt. Alternatively, merchant builders may simply need more leverage to keep liquidity available for other unforeseen opportunities. When looking to build your capital stack, your first option should be a mezzanine loan and preferred equity.
Mezzanine Financing in multifamily is the middle ground between debt and equity financing. With a mezzanine loan, the lender reserves the right to convert to an equity interest in the subject property in case of default, but only after venture capitalists and any other senior lenders are paid. As such, mezzanine loans remain one of the highest-risk forms of debt for lenders, but also offer some of the highest returns in comparison to other debt types. Because of the nature of the loans, mezzanine financing often receives rates between 12% and 20% per year, and sometimes even as high as 30%. Mezzanine loans are often used by merchant builders looking to maximize their IRR while also maximizing leverage since the cost of equity is often more expensive than non-recourse debt.
What is mezzanine financing and how does it work?
Mezzanine financing in commercial real estate authorizes a lender to convert their debt into equity in the event that a borrower defaults. For example, if the borrower fails to pay the debt in a timely manner, the lender has the right to take action by taking a portion of the investment property and then selling it to pay off that debt. Mezzanine financing can be 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.
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 (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.
What are the advantages and disadvantages of mezzanine financing?
The advantages of mezzanine financing include flexible financing, low probability of losing ownership or control of a property, and quick closing. However, mezzanine debt is riskier due to a lack of collateral from the borrower, so interest rates tend to be higher (10-20%) and more covenants are 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. Mezzanine lenders are usually granted a lien against the entity that owns the property.
The drawbacks of mezzanine debt include higher interest rates, lender-friendly covenants, not allowed or heavily restricted by agency lenders, high fees and additional legal costs, and lenders are granted a lien against the borrowing entity.
What types of commercial real estate projects are eligible for mezzanine financing?
Mezzanine financing is available for a variety of commercial real estate projects, including first-time investments, expansions, and construction projects. According to Commercial Real Estate Loans, mezzanine financing typically has 1-5-year terms, though some may go up to 10, and many mezzanine loans are interest-only. The minimum loan amount is $2 million, and the term is coterminous with the first lien. Leverage is up to 90% LTV on stabilized property and 85% LTC on construction, and nonrecourse options are available.
What are the typical terms of a mezzanine financing agreement?
Mezzanine financing typically has loan amounts of $3 million and up, with terms coterminous with the first loan (typically between 5-7 years). Interest rates are typically between 9% - 16% (interest only), and fees are 3% - 6%. Maximum LTV is 85%.
Before a CMBS borrower can finalize their mezzanine loan, both the original CMBS borrower and the mezzanine lender must typically sign an inter-creditor agreement, defining the rights and responsibilities of each lender to each other.
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 risks associated with mezzanine financing for commercial real estate projects?
The risks associated with mezzanine financing for commercial real estate projects include debt being expensive and driving up blended debt cost, not being allowed by all lenders, being more expensive than equity, providing higher leverage, and having high fees and additional legal costs.
Debt can be expensive and drive up blended debt cost (Source 1). Not allowed by all lenders (Source 1). Cheaper than equity (Source 1). Provides higher leverage (Source 1). Interest is tax deductible (Source 1). Can be extremely expensive (up to 20% for some borrowers) (Source 2). Not allowed by all lenders (Source 2). High fees and additional legal costs (Source 2).