What is Mezzanine Financing?
Mezzanine financing enables a property or business owner to put less money down. It is different from a real estate loan in that it is not secured by a lien on the property but by an ownership interest in the real estate or business. Mezzanine debt fills the gap between debt and equity on highly leveraged real estate or business transactions.
Mezzanine Debt is Not Really a Loan
In actuality, mezzanine debt is not really a loan. It is an assignment of the borrower’s interest in the entity that owns the property in exchange for an equity contribution which lowers the borrower’s cash injection. The mezzanine debt will have a preferred position in the ownership entity and receive principal and interest before the borrower draws any income from the net cash flow, or from the sale of the property or business. Mezzanine debt is in a subordinate position to the first mortgage, but is in a superior position over the owners equity in the business or real estate. Borrowers which are referred to as sponsors retain control of the enterprise, and capture all the upside of the property or company appreciation.
Why is Mezzanine Financing Used
Mezzanine debt is used to lower the cash equity requirement of the borrower. In large commercial real estate transactions, the first position lender will often only go up to 75% loan to value and not allow subordinate debt to increase the leverage. But they often allow a 10% mezzanine debt to partner to the ownership entity that is providing additional equity. Most first mortgage lenders require the borrower to have at least 15% skin in the game when using mezzanine financing.
Mezzanine Debt/Financing Rates?
Mezzanine debt is expensive and ranges from 12% to 20% interest. This is because the mezzanine lender is taking a substantial risk by not being secured by the real estate. This rate might seem unaffordable, but if it only represents 10% of 85% financing, the blended rate of the first mortgage and the mezzanine debt will likely make sense. For example: If the 75% first mortgage is at 5.00% and the mezzanine loan is at 16.00%, the blended rate will be 8.20% In exchange for getting 85% financing this might be well worth it. Because mezzanine financing has become more competitive, rates are coming down. For multifamily real estate repositioning or rehab, bridge lenders often partner with mezzanine lenders that offer very competitive rates as low as libor plus 4.00% to 6.00%. Keep in mind that the first mortgage lender and the mezzanine lender will require that the entire combined debt have a debt service coverage ratio (DSCR) of approximately 1.20. On repositioned properties as low as 1.10. Mezzanine lenders charge a transaction fee along with legal fees.
Where is Mezzanine Debt Used?
Mezzanine debt is used in commercial real estate purchases, refinances and ground up construction. It is also used in the acquisition, refinance and development of business transactions. It is a way for business owners and investors in commercial real estate to grow faster because of using less of their cash equity. Most commercial banks because of banking regulations do not allow mezzanine financing. Commercial Mortgage Backed Security (CMBS) lenders, insurance lenders, bridge lenders and private lenders allow mezzanine debt.
Examples of How Mezzanine Debt can Benefit an Investor
Here is an example of a mezzanine loan that illustrates how a mezzanine lender is brought in to help an investor have a smaller down payment on a commercial property.
A firm wants to purchase a company for $50 million. Conventional commercial lenders may only want to fund a maximum of 75 percent loan to value of the company, which would be $37.5 million. The firm (sponsor) does not want to put down $12.5 million. Thus, it finds a mezzanine lender to invest $5 million.
With $42.5 million in financing, the firm must only put in $7.5 million of its own funds for the purchase. This potentially leverages the purchaser’s return, and at the same time the purchaser puts down a smaller amount of capital.
You buy a small restaurant. The restaurant has an operating income of $100,000 annually, and the restaurant owners will let you buy it for $500,000. You do not have $500,000 to invest. Thus, you find a lender who will lend $300,000 at an annual rate of 8 percent.
Here is how the finances are structured:
- The lender finances $300,000 at an 8 percent annual rate.
- You (the investor puts down $200,000
Now we can figure the return on the investment. The company makes an annual operating income of $100,000. Now subtract from it $24,000 annual interest that the lender gets. This yields $76,000 pretax profit. Let’s assume a 35 percent tax rate on the profit which yields $49,800 pretax profit.
Your annual return on your $200,000 investment is $49,400. This is an annual return of 24.7 percent which is a good return.
Well, let’s look at what could happen if you lowered your down payment. What if you got a 2nd lender in addition to the first lender to give you higher leverage?
So, let’s say you find a mezzanine lender who will lend $100,000 at an annual rate of 15 percent.
Here is how the finances are structured:
- The first lender finances $300,000 at an 8 percent annual rate.
- The mezzanine lender contributes $100,000 of debt financing at 15% per year.
- You, the investor only put down $100,000.
If you start with the same operating income of $100,000, you have to subtract $24,000 interest for the first lender, and interest of $15,000 for the mezzanine lender. Your pretax profits drop to $61,000. From this you subtract 35 percent tax, and you now earn annually $39,650.
By getting the mezzanine lender, after tax profits dropped from $49,400 to $39,650. But, the investment (down payment) was cut in half. Your investment was $100,000 instead of $200,000.
Thus, your total annual profit went down, but on the other hand, the return on investment increased from an annual 24.7 percent profit to an annual 39.7 percent profit.
Keep in mind that the calculations here are based on the restaurant performing as planned. There is risk involved in the ownership of a company, and results are far from guaranteed. This is why mezzanine lenders charge such high interest rates – they know there is quite a bit of risk involved.
By Terry Painter/President Apartment Loan Store and Business Loan Store