If you are struggling to find a reasonable equity capital solution for your CRE financing needs, a mezzanine loan may be what you are looking for. Especially in today’s economic environment, high-leverage financing can be difficult to secure. Mezzanine loans can bridge the gap between traditional secured debt and equity financing.
The word “mezzanine” refers to a floor between two main floors in architecture. The word has been borrowed to also refer to a loan that sits between an equity stake and a traditional bank loan on the capital stack.
When a mezzanine loan is used, the first mortgage lender that issues the senior debt gets paid first at a certain interest rate. The mezzanine lender gets paid second (in second position). They may convert the debt into an equity stake, if the borrower is unable to pay the loan on time. Finally, the original equity holders get paid last. But, of course, there is no limit to how high their returns can be.
How is a Mezzanine Loan Structured?
Since a mezzanine loan is a capital source between senior debt and equity, it allows borrowers to maximize leverage without diluting their own equity position. Typically the mezzanine interest rate will be between 8% and 16%, depending on the risk involved and other underwriting factors. Quite often, only the interest is due to be paid back with no equity participation.
Advantages of a Mezzanine Loan for Your Project
A mezzanine loan comes with some major advantages for real estate investors. The biggest advantage is that the investors retain a controlling position in the project, and there is no dilution. The loan typically comes with fewer restrictions and more flexibility than a conventional loan. Additionally, it will usually be much less costly than an equity position. Private equity investors will often want at least a 20% return on investment, but since the mezzanine lender is more senior to the equity holders, they will accept a much lower interest rate.
Mezzanine loans typically provide LTV from 75% to 90% in combination with the senior debt. For borrowers seeking a high-leverage solution, mezzanine capital provides better terms than senior debt alone.
Securing a Mezzanine Loan
There are two main ways in which most mezzanine loans are secured. The first is with a second mortgage, which is the most common but not always possible. In a second mortgage, the mezzanine lender is recorded on the title in second position, behind the original mortgage lender. Of course, for this to happen, the first mortgage lender must approve the structure with acknowledgement, or recognition to the second lien holder as well as an intercreditor agreement.
In cases where a second mortgage is not possible, the mezzanine loan can be secured with a Perfected Pledge of Equity. The equity in the entity that owns the property is pledged as collateral, and to perfect it is to file a UCC-1 statement with the lender. The UCC-1 is a legal notice filed by creditors for any business loans under the Uniform Commercial Code (“UCC”). This procedure establishes priority over which the collateral may be seized relative to any other creditors.
Unlike a mezzanine loan, preferred equity capital is not secured and may be structured as “debt-like” to mimic a 2nd or 3rd position loan. Preferred equity structures are often used in situations where a mezzanine loan cannot be approved by the senior lender.
As is true with many private loans, payments are generally interest only, as opposed to amortizing. Typically, all or some of the interest due may be paid on a monthly basis with the rest to be accrued or Paid in Kind (PIK). These flexible terms make mezzanine loans very attractive to real estate investors who need capital and flexibility to complete their projects.
If you are looking for financing for a commercial real estate project, a mezzanine loan may be the perfect solution. Most lenders are looking for at least a five or ten million dollar minimum loan amount, but we have routinely been able to fund loans for our clients in the two million dollar range.
These loans are perfect for those seeking flexibility but do not want to dilute their equity stake. If you think a mezzanine loan may be the right solution for your project, give us a call and learn how we can structure your deal.