The cost of a mezzanine loan depends on the lender's risk assessment and factors such as the borrower's creditworthiness and cash flow affect the cost of the loan. Interest rates for mezzanine loans usually range from 10% to 20%, but additional fees apply. Lenders often require borrowers to contribute equity in exchange for the loan, known as an "equity cushion" or "equity kicker," is a percentage of the loan amount. The equity contribution typically ranges from 5% to 15%, depending on the borrower's financial situation.
Introduction
When businesses find themselves in need of additional capital to bridge the gap between traditional debt financing and equity financing, mezzanine loans can offer a powerful solution. However, it’s essential to understand the costs involved and explore alternative financing options before making a decision.
Costs dependent upon lender’s risk assessment
The cost of a mezzanine loan primarily depends on the lender’s risk assessment, which takes into account factors such as the borrower’s creditworthiness and cash flow. Typically, borrowers are charged interest rates ranging from 10% to 20%. On top of the interest, there are additional fees associated with obtaining the loan, including origination fees, legal/accounting costs, and due diligence expenses.
“Equity cushion” or “equity kicker”
In addition to these upfront costs, lenders often require borrowers to contribute equity in exchange for the loan. This equity investment, known as an “equity cushion” or “equity kicker,” is typically a percentage of the loan amount, typically ranging from 5% to 15%, depending on the borrower’s financial situation.
Prepayment penalties
It’s important to note that mezzanine loans frequently come with prepayment penalties. If the borrower attempts to pay off the loan before it reaches maturity, they may face high interest rates or additional costs.
To provide a clearer picture, here’s an example of what a mezzanine financing loan term sheet for a commercial property loan might look like:
- Amount: $1.5 million
- Term: Coterminous with the first mortgage (5 years)
- Interest Rate: 14% (interest-only)
- Origination Fee: 4.5%
- Maximum Loan-to-Cost (LTC): 85%
- Mezzanine loan rates can vary depending on the term and other factors. Here are some examples:
| Term | Fixed-rate | Floating rate | Max LTV | Max amortization |
| 5 years | 5.24% to 8.24% | N/A | 75% investment | 30 years |
| 7 years | 5.91% to 8.91% | N/A | 75% investment | 30 years |
| 10 years | 6.56% to 9.56% | N/A | 75% investment | 30 years |
Real estate example
Let’s consider an example to illustrate the use of mezzanine financing. Imagine a real estate investor wants to purchase a commercial property valued at $4 million. With a loan-to-value (LTV) ratio of 65%, they need to borrow $1.6 million. In this case, they could opt for a mezzanine loan to obtain the additional funds. The loan terms might involve interest-only payments of 12% over ten years, with no amortization or prepayment penalties. The lender would provide the full capital amount without requiring further equity contributions, unless specified by certain covenants in the agreement.
Alternative financing options
However, if the cost of a mezzanine loan seems prohibitive, there are alternative financing options worth considering:
- Senior debt financing: This type of loan allows borrowers to secure up to 80% or even 90% of their project costs, with lower interest rates and more flexible repayment terms than mezzanine loans.
- Joint venture equity: Partnering with an investor who provides capital in exchange for ownership rights to the property can be another viable option.
- Equity infusion: If you have sufficient cash available, consider an equity infusion instead of taking out a loan. This approach allows you to own 100% of your investment without incurring loan fees or interest payments.
Conclusion
In summary, mezzanine financing can serve as a valuable tool for businesses seeking to bridge the funding gap between traditional debt financing and equity financing. While mezzanine loans generally involve higher interest rates than traditional debt lenders, they often offer more flexible terms and greater freedom in how the funds can be used. However, it’s crucial to carefully evaluate the costs involved and consider alternative financing options to make an informed decision that aligns with your specific financial needs.
