Mezzanine financing is an important funding tool for real estate transactions.
Mezzanine financing helps real estate investors bridge the gap between their equity and the senior debt a lender will provide them. It’s usually in the form of subordinated debt, though it can have an equity component. While an investor will pay a higher interest rate for mezzanine financing, it can enable them to earn a higher rate of return on their investment.
What is a mezzanine loan?
Mezzanine financing gets its name from the mezzanine floor of a building, which is right above the ground floor. In this case, however, it’s right above senior debt in the capital stack of an investment.
A mezzanine loan is additional debt an investor will take on to finance an acquisition or expansion project. As such, it reduces the amount of equity an investor needs when putting together funding. Mezzanine financing usually has the following characteristics:
- It’s subordinate to senior debt like a mortgage loan, but it has priority over preferred and common equity in the event of bankruptcy.
- It has a higher interest rate than senior debt.
- It’s typically not secured by any collateral.
- It can be interest-only instead of having the principal amortized over the life of the loan.
- It’s often of a shorter duration than secured debt.
How mezzanine financing works
Mezzanine financing works to fill the gap between the senior debt financing available to fund a real estate deal and the equity an investor has available to put into the transaction. In a conventional real estate transaction, an investor might be able to cover senior debt for up to 80% of a property’s value, which leaves them with 20% to cover with equity, such as cash on hand. If the borrower doesn’t have enough capital to bridge that, they either need to bring on other equity investors or find some other funding source, such as preferred equity or mezzanine financing.
Let’s look at an example using an investor who would like to buy some commercial real estate that has a $1 million purchase price. This property generates $100,000 of annual net operating income. The investor can get $600,000 in financing for the purchase from a senior lender at a 5% interest rate. As such, the investor would need $400,000 in additional capital to close this deal. Assuming they had the cash, here’s a look at the current pre-tax return profile of this deal:
| METRIC | AMOUNT |
|---|---|
| Annual operating income for the property | $100,000 |
| 5% annual interest on the $600,000 senior loan | $30,000 |
| Pre-tax income | $70,000 |
| Annual pre-tax return on $400,000 equity investment | 18% |
Data source: Author’s calculations.
However, if this investor didn’t have $400,000 in capital to commit to this deal, they would have to consider alternative funding options, such as bringing on other equity investors to help bridge the gap. Another option would be to secure a mezzanine loan from another lender. Here’s how the math would work out if they obtained $200,000 in mezzanine financing at a 10% annual interest rate:
| METRIC | AMOUNT |
|---|---|
| Annual operating income for the property | $100,000 |
| 5% annual interest on the $600,000 senior loan | $30,000 |
| 10% yearly interest on the $200,000 mezzanine loan | $20,000 |
| Pre-tax income | $50,000 |
| Annual pre-tax return on the $200,000 equity investment | 25% |
Data source: Author’s calculations.
As that table shows, the investor would reduce their equity financing requirement while boosting their return on investment by taking out the mezzanine loan.
The benefits of mezzanine financing
Mezzanine financing has two main benefits to the borrower:
1. It reduces the amount of equity needed to fund an acquisition or expansion project.
2. It increases the return on their equity investment.
The reduction in the equity requirement has some important advantages. For example, an investor can use that equity for another deal, which would further leverage their returns. Meanwhile, it also aids those who don’t have enough capital to satisfy the need since they won’t have to bring on other equity financing partners and dilute their ownership interest.
A mezzanine investment, likewise, has several benefits to the lender, including:
- The ability to earn a higher interest rate on the loan they provide to a borrower.
- Lower risk of loss, as these loans have a higher priority than both common and preferred equity in the event of a bankruptcy.
As such, mezzanine debt can offer the lender an equity-like return with a bond-like risk profile. While it’s not as low risk as secured debt, nor is the return upside as much as equity, mezzanine lending can offer attractive risk-adjusted returns.
How to determine whether mezzanine financing is the right choice
An investor needs to weigh the pros and cons of utilizing mezzanine financing to decide whether it’s their best option. While it reduces the amount of equity they need to put up in a transaction and can boost their returns on that investment, it also increases their risk. It raises the leverage level of the property, which cuts both ways as it increases profits when the investment pays off but results in bigger losses if something goes wrong. Further, with less equity to cushion the blow of losses, real estate investors risk a complete loss of capital they put into a deal.
Mezzanine financing helps bridge the funding gap in real estate
A mezzanine loan is an important funding tool for real estate investors. It can help cover the difference between the equity they have to put into a transaction and the senior debt financing available from lenders. While these loans increase a deal’s risk profile, they also enhance the return potential.
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