When it comes to financing commercial real estate projects, one option that has gained attention is mezzanine debt. Mezzanine debt combines features of both traditional debt and equity, positioning it between the two in the company's capital structure.Introduction
Mezzanine debt typically carries higher interest rates ranging from 12% to 20%. This higher cost is due to the increased risk for the lender, as mezzanine debt is not secured by real estate assets. While this might initially seem unaffordable, it’s important to consider the overall financing structure. If the mezzanine debt represents only 10% of an 85% financing package, the blended rate with the first mortgage can still make sense.
Example
To illustrate, let’s assume a scenario where a 75% first mortgage carries an interest rate of 5.00% and the mezzanine loan is priced at 16.00%. The blended rate, taking both loans into account, would be 8.20%. In exchange for obtaining 85% financing, this blended rate could be a worthwhile option. It’s worth noting that as mezzanine financing becomes more competitive, rates are starting to come down. In fact, for multifamily real estate repositioning or rehabilitation projects, bridge lenders often collaborate with mezzanine lenders who offer rates as low as libor plus 4.00% to 6.00%.
Both the first mortgage lender and the mezzanine lender will require a debt service coverage ratio (DSCR) of approximately 1.20, with repositioned properties potentially as low as 1.10. Additionally, mezzanine lenders typically charge transaction fees and legal fees.
Uses in commercial real estate
Mezzanine debt finds utility in various areas of commercial real estate, including purchases, refinances, ground-up construction, and the acquisition, refinance, and development of business transactions. It allows business owners and real estate investors to accelerate growth by utilizing less of their own cash equity. Notably, most commercial banks do not offer mezzanine financing due to banking regulations. However, other lenders, such as Commercial Mortgage Backed Security (CMBS) lenders, insurance lenders, bridge lenders, and private lenders, do provide this financing option.
How it works?
Now let’s delve deeper into how mezzanine financing works. Mezzanine financing possesses characteristics of both debt and equity. It holds a subordinate position to senior debt but has a higher priority compared to common and preferred stock. In essence, it can be viewed as higher-cost debt due to its elevated interest rates, or as cheaper equity with reduced dilution and overall cost of capital. Moreover, mezzanine financing enables existing owners to maintain control over the company, which is a significant advantage.
Unlike senior loans, mezzanine loans are often seen as a more patient form of capital. These loans have longer maturity periods, typically ranging from 5 to 7-8 years, and do not require amortization prior to maturity. During this period, only interest payments need to be made, and in case of liquidity constraints, senior lenders may even pause the interest payments.
Risk and default
However, mezzanine financing does carry a higher level of risk, leading to higher rates of return for lenders. These rates of return typically range from 12% to 20% per year.
In the event of default, mezzanine financing includes subordinated loans with flexible repayment terms and the potential for conversion into equity. However, in bankruptcy scenarios, mezzanine lenders are among the last to receive payment.
It is important to note that mezzanine financing comes with high interest rates and often includes warrants, which grant the lender a stake in the company’s shares. These warrants are typically part of the mezzanine plan, referred to as mezzanine equity. In the event of default, the debt can be converted into equity, and over time, the lender may also acquire an equity stake along with the money paid out.
Conclusion
In conclusion, mezzanine debt serves as an attractive financing option for commercial real estate projects, offering a blend of debt and equity features. While it carries higher interest rates due to the inherent risk, the overall financing structure and the ability to leverage existing equity can make it a viable choice for investors and business owners. As the competition in the market increases, rates are becoming more competitive, making mezzanine financing an avenue worth exploring in 2023.
