Mezzanine financing is a hybrid financing that blends the features of debt and equity financing. Mezzanine financing is a non-traditional type of financing that is used for large projects and growing businesses.
Before attempting their exam, real estate students must learn financing definitions like mezzanine financing. I’ve noticed that most real estate students can’t differentiate between various types of loans and financing options, and that’s why I’m here today.
In this post, I’ll explain mezzanine financing with the help of examples so that it’s easy for you to learn.
What Is Mezzanine Financing?
Mezzanine financing is a financing tool that combines debt and equity financing. This type of financing is also known as subordinated financing because the lenders have a second priority in these loans after the senior lenders.
Real estate investors and developers have two options to finance their properties. One is the most common, which is known as a loan or mortgage. This debt funding allows borrowers to get funds for an agreed interest rate. The other financing option is equity financing, in which the lender gets an equity share in the property for providing funds to the borrower.
The third one, known as ‘mezzanine financing,’ is a combination of the two types of financing.
Mezzanine financing is a junior mortgage, and mezzanine loans are riskier for lenders than other types of loans. Mezzanine loans are subordinate to senior mortgages, but they are given priority to common and preferred equity.
If the senior mortgage can’t cover the cost of purchasing and developing a property, the developers can use mezzanine loans to cover the expenses in real estate projects. Mezzanine debt offers more flexible repayment terms than conventional loans. However, when it comes to borrower’s default, the lenders are paid after the senior debts have been paid. Lenders offering mezzanine loans are almost the last to be paid off after default. These loans are senior to equity shares only.
Structure of Mezzanine Financing
The following is a mezzanine financing structure that will help you understand how mezzanine financing works in real estate:
|Senior loans and mortgages|
From the above table, you can see that mezzanine financing is in the middle of debt financing and equity financing. This is why it’s called mezzanine financing, as it is one level above equity financing.
Senior mortgages have priority for all types of financing. Mezzanine financing is senior to equity and subordinate to senior debt, but it is still considered the riskiest for the lender. However, since the lender can charge high rates on this type of loan, they can get the highest returns per year. The following are the key concepts of mezzanine debt in real estate:
The amount of a real estate mezzanine loan depends on the mezzanine lenders and the senior debt. The percentage of this amount is much smaller than the senior debt since this is a subordinated debt.
Since this is a subordinated debt, the risk is higher than other debt types. Mezzanine lenders, thus, demand higher interest rates to reduce their risk in the loan.
Mezzanine debts can be secured or unsecured. With secured mezzanine loans, the lender gets a second position in a lien on the property. This means that the mezzanine lenders will be paid second in line after the senior lender has been paid. Their claim to the property is behind the senior lenders but ahead of equity shareholders.
Mezzanine financing has a shorter term than senior debts. The term can vary according to the loan amount and the borrower’s credit history.
The monthly payments on mezzanine financing are mostly interest-only.
How Mezzanine Financing Works
Mezzanine lenders mostly work with borrowers with a good credit history and excellent financial performance. For example, companies can use mezzanine financing to acquire an existing business or to expand their services and operations globally. The following terms explain how mezzanine financing works:
Interest and Repayment
The interest rate on mezzanine loans is higher than on conventional loans. With conventional loans, the interest rate is mostly below 10%, but with real estate mezzanine loans, it is common to have rates in two digits.
The borrower has several repayment options depending on the terms of the agreement. Mostly, large companies use mezzanine financing, and the lenders get payment from the monthly cash flows of the companies.
Mezzanine financing has lower priority than senior debt if the borrower fails to pay or goes bankrupt. For instance, if a company shuts down, it will have to sell its properties and assets to generate cash and pay off its debts. If the amount obtained from selling the property and assets is not enough to pay all the lenders, the lenders with higher priority will be paid.
Pros of Mezzanine Financing
- Quick access to capital
- Multiple repayment options
- Increase in capital structure
- Regular interest payments for lenders
- Tax-deductibility for borrowers
- An additional source of income
- Higher return on investment for lenders
- The borrower can restructure a mezzanine loan into a senior loan
Cons of Mezzanine Financing
- Risk of equity loss for borrower
- Risk of investment loss for the lender
- Shared control with mezzanine lenders
- More expensive than traditional financing
Mezzanine Financing Example
A company, XYZ, wants to purchase a property worth $1,000,000. They applied for a loan at a bank, and they are ready to offer a mortgage of 70% of the property price, that is, $700,000, and an interest rate of 4%. This is the senior mortgage, and the lender is referred to as a senior lender.
Now the company must raise the remaining $300,000 through equity. However, the company XYZ doesn’t want to tie this huge amount to equity, and it approaches a mezzanine lender.
The mezzanine lender offers $200,000 but at an interest rate of 8%. The equity requirement is now $100,000, and the company can put up this amount to purchase the property. The following table explains how the total capital will be raised with and without mezzanine financing:
|With Mezzanine Financing||Without Mezzanine Financing|
|Funds from the bank: $700,000||Funds from the bank: $700,000|
|Funds from the mezzanine lender: $200,000||No mezzanine lender|
|Total amount raised= $900,000||Total amount raised: $700,000|
|Equity requirement= $100,000||Equity requirement= $300,000|
The table above shows how mezzanine financing helps bridge the debt financing and equity gap. If the company defaults on the loan, the senior lender will be paid earlier than the mezzanine lender.
Frequently Asked Questions
How Does Mezzanine Financing Work?
In mezzanine financing, the borrower gets funds from a mezzanine lender, and the lender will cover a portion of the equity the borrower has provided. The lender doesn’t use the property as collateral in the loan; thus, it is riskier, and interest rates are higher. In case of default, when the property is sold out to cover the loss, the mezzanine lender has a lower priority than the senior lender.
What Is the Collateral for Mezzanine financing?
Unlike a senior loan, a mezzanine loan is not directly collateralized by a real estate property. Instead, the loan is secured by the borrower’s equity in the property. If the borrower defaults on the loan, the senior lenders have the right to foreclose on the property. The mezzanine lenders can foreclose on the pledge and take over the equity share in the property.
What Is a Mezzanine Investment?
A mezzanine investment is an investment that is structured between the borrower’s senior debt and common equity. With this type of investment, the investor receives a higher return on investment than the traditional forms of lending.
Why Do Companies Use Mezzanine Financing?
Companies use mezzanine financing because of a few advantages. First, with mezzanine financing, companies can easily purchase commercial properties. They get quick access to funds, better rates, and flexible repayment terms.
The main aim of mezzanine financing is to provide an alternative source of capital for property buyers in areas with no investment opportunities. Another advantage of this type of financing is the chance of getting a good return on investment. Mezzanine financing is riskier than conventional loans, but it can give higher returns too.
What to Know for the Real Estate Exam
Mezzanine financing is a hybrid lending tool that combines the features of debt financing and equity financing. It is a short-term financing option for real estate investors and developers who need to fill the gap between their debt and equity financing.
Mezzanine financing increases the total capital and equity returns. However, the period for return on investments is long. There is no amortization of principal in these loans, and the borrower has to make interest-only payments.
Now that you’ve read the entire post, I hope you understand how mezzanine financing works. If you want to learn more terms like this, don’t forget to go through our real estate flashcards for a better learning experience.