Mezzanine Debt – 6 Point Financing Guide

Real estate developers have many options when it comes to financing their projects. Mezzanine financing is also one of the most important! Related terms include mezzanine loans, mezzanine debt, and mezzanine capital. By using mezzanine debt, investors can fill the gap between their equity investment and their primary loan. 

What is Mezzanine Financing?

Mezzanine financing refers to a tier of capital that resides between the primary debt and equity tiers in a company’s capital structure. Real estate developers typically take on mezzanine financing after securing the project’s primary loan. They do this in order to increase their leverage and reduce their out-of-pocket equity commitment. Mezzanine loans typically start at $5 million, and can be much larger. Normally, mezzanine lenders are interested in projects in which the property is worth at least $15 million. Usually, mezzanine loans carry interest rates in the 12% to 20% range.

Point 1: Types of Mezzanine Financing Instruments

In most cases, mezzanine financing refers to unsecured debt, as well as preferred stock. The most common version is unsecured, subordinated loan debt, with the possible inclusion of equity participation such as co-investment rights and convertible debt. Mezzanine financing usually provides between 10% and 40% of the capital investors commit to a real estate project (construction, acquisition and/or rehabilitation). 

Point 2: Understanding the Mezzanine Structure

When a developer takes out a second mortgage, the provider receives a second-lien on the project’s property. If the developer defaults, the first-lien holder can foreclose, seize the property and sell it. The second lien holder gets the money left over, if any, after the first-lien holder recoups its money. 

Contrast a second mortgage with a mezzanine loan, in which the mezzanine lender has no direct interest in the project’s real property. Developers typically set up a limited liability company (LLC) for each project. The project’s property secures the first-lien debt. However, it is the LLC’s equity (known as membership interests, analogous to stock in a corporation) that collateralizes mezzanine debt. 

Before taking a mezzanine loan, a project’s capital stack typically consists of the following, ranked in seniority:

1. A hard money loan (60% of total capital) or mortgage (~75%)
2. Equity cash and land (25% to 40%)

Adding a mezzanine loan to the mix results in the following capital stack:

1. Hard money loan (60%) or mortgage (~75%)
2. Mezzanine loan (10% to 40%)
3. Equity cash and land (0% to 15%)

As you can see, taking a mezzanine loan frees up the developer’s equity for use elsewhere. Leverage reaches as high as 100%.

Point 3: Default Considerations

Should the borrower default on the mezzanine loan, the mezzanine lender need not go through the usual foreclosure process that can take the first-lien holder a year or more. Instead, it can do a fast foreclosure on the LLC under Article 9 of the Uniform Commercial Code, a process that takes weeks rather than years. If the foreclosure succeeds, the mezzanine lender seizes the membership interests in the project’s LLC, thereby assuming ownership of the project property.

The difference is that when real property secures a loan, foreclosure is a judicial procedure that can take a long time to complete. When personal property (i.e., stock, LLC interests) secures a loan instead, the streamlined UCC foreclosure procedure can proceed expeditiously.

Point 4: Uses for Mezzanine Financing

As a developer, you should be familiar with these three uses of mezzanine financing:

1. Equity Extraction: With a mezzanine loan, you can extract cash out of a building whose value has appreciated since you acquired it. This can come in handy if you cannot refinance the existing mortgage, perhaps due to a large prepayment penalty or lock-out clause. For example, if you have a $12 million mortgage on a $25 million building, you might take a mezzanine loan for $6 million without disturbing any loan covenants on the mortgage.
2. Value-Added Deal: You can use a mezzanine loan to add value to an existing property. Suppose you own a slightly rundown office building in a good location, with a vacancy rate of about 50%. You bought the building for $22 million 10 years ago and have a $12 million balance remaining on a mortgage with a prohibitively high prepayment penalty. You might be able to secure a $10 million mezzanine loan and use some of the loan proceeds for renovations that will increase the building’s value to $29 million, dropping the loan-to-value ratio from 100% to 75%. 
3. New Construction: You might not want to commit too much of your corporation’s cash to a construction project. Instead, you can use a mezzanine loan to reduce your cash equity in the project. In our example, suppose you want to construct a $28 million office building using a 60% hard money loan of $16.8 million, requiring you to kick in $11.2 of your own money. Alternatively, you can layer on a mezzanine loan for $5 million, bringing the total loan-to-cost ratio to (($16.8M + $5M)/$28M), or 78% and cutting your cash equity to $6.2 million from $16.8 million.

Point 5: Leverage from Mezzanine Financing

Let’s return to the office building construction project that will, when stabilized, bring in net operating income (NOI) of $4 million per year. Assume the hard money loan carries an 8% interest rate, while that on the mezzanine loan is 15%. The tax rate on the development corporation is 20%.

Before the mezzanine loan, the interest charge on the hard money loan is (0.08 x $16.8M), or $1.34M. Pretax income is $4M – $2.66M, or $1.34M. After-tax income is (1 – .20) x $1.34M, or $1.075M. The annual return is $1.075M/$11.2M, or 9.6%.

After the mezzanine loan, the interest on the hard money loan remains $1.34 million. The interest on the mezzanine loan is (0.15 x $5M), or $0.75M, creating a total interest charge of 2.09M and pre-tax income of is $3M – $2.09M, or $0.91M. The after-tax income is (1 – .20) x $0.91M, or $0.728M. Thus, the rate of return is $0.728M/$6.2M, or 11.7%.

The result is that the mezzanine loan raises your rate of return by more than 2 percentage points while cutting your equity by $5 million. This is the benefit of boosting your leverage from 60% to 78%. The cost is an after-tax increase in interest charges of (0.80 x ($2.09M – $1.34)), or $0.60M.

Point 6: Payment in Kind (PIK) Toggle

In some situations, a mezzanine lender will include a PIK toggle feature in its loan. This feature allows the borrower to roll the loan interest into the loan balance. The PIK toggle feature is helpful when the borrower can’t make the next interest payment because it can delay the interest until a later time. First-lien debt doesn’t offer this feature.

Is Mezzanine Financing Right for Me?

Mezzanine financing makes sense for the three use cases we described earlier – equity extraction, value-added deal and new construction. Each use case shows how you can benefit by layering on a mezzanine tier to your capital stack. Before proceeding, you should also check these factors:

1. LLC vs Corporation: In the discussion of leverage, we assumed the borrower was a corporation with a tax rate of 20%. You would have to redo the calculations of after-tax income if the borrower was an LLC. An LLC is a tax-free, pass-through entity. The taxes are on the borrower’s personal income, which introduces two complexities. The first is that the top personal tax rate is 37%, not 21%. The second is that the LLC probably qualifies for the 20% qualified business deduction. Thus, the percentage return on the mezzanine loan might be higher or lower than the return for a corporation.
2. Interest-Only Loans As described above, a mezzanine loan might contain the PIK toggle feature that reduces your risk of default, foreclosure and bankruptcy. The feature allows you to roll your interest into the loan principal. For construction loans, both the primary lender and the mezzanine lender might offer interest-only loans until the property earns its certificate of occupancy.
3. Fast-Growing Companies: If your company is growing fast, your chances of refinancing your debt rises. You might end up with a reduced overall interest charge by refinancing your senior and mezzanine loans into a new senior loan.
4. Debt Service Coverage Ratio: Most lenders require a DSCR of at least 1.20x. This requirement might limit the amount of mezzanine financing you can assume since its interest rate is about double those of senior debt.