Mezzanine Debt is a type of financing used to increase leverage in a commercial real estate transaction. This instrument bridges the gap between debt and equity financing and is secured by an interest in the entity that owns the real property rather than on the real property itself. Investors use mezzanine financing to achieve growth goals that require capital beyond what senior lenders will offer. Oftentimes, this form of financing is used to reduce the equity requirement of both the borrower or investor and reduces the investor’s “skin in the game.” It carries a higher interest rate than senior debt but is significantly less expensive than equity in terms of the overall cost of capital. Rather than raising additional equity for capital needs, this form of financing allows existing owners to maintain control and avoid dilution of their control. Mezzanine financing also increases IRR (Internal Rate of Return) and interest is tax-deductible. In most financing scenarios, investors looking to build their capital stack should often consider mezzanine debt first.
Mezzanine debt is considered one of the highest-risk forms of debt in the capital stack. It merges the gap between debt and equity financing, considered a hybrid debt issue and ranking above pure equity but below pure debt. As a high-risk vehicle, mezzanine debt also offers higher returns to lenders in comparison to other debt forms, ranging between 12% and 20% yearly.
When a borrower decides to invest in a commercial real estate property, they typically first go through the traditional bank route to secure financing, as these loans are often characterized by lower interest rates and longer repayments periods than other lenders. For a bank, borrowers are typically expected to put down between 20% and 30% down payment of the property’s purchase price. Oftentimes, if a borrower does not want to utilize their own money for the down payment, they may turn to mezzanine debt to leverage the loan to cover the equity fee at closing.
The borrower takes out a mezzanine loan with a mezzanine lender (who will cover some of the equity for the project that the borrower would have provided). The investment vehicle utilized by mezzanine lenders is not secured by real estate, so this loan type is much riskier and leads to higher interest rates. In the case that the project fails and the borrower defaults, the senior debt holder in the deal (the bank, agency or debt fund) must be paid back first, prior to the mezzanine lender. This is why mezzanine debt is more expensive; mezzanine lenders need to protect themselves through higher financial security, that is, higher rates, in the case that the project does not go according to plan.
In the case of Mezzanine Debt, a mezzanine lender provides a loan to finance a portion of the property. On the other hand, preferred equity involves an investor getting a stake in the actual property, which results in fixed dividends as opposed to a return linked to the property's cash flows. With the preferred equity investor given more control in the actual deal, in the case of issues such as default, the preferred equity provider can remove the owner from their managerial position. As such, this investment vehicle is a risk for borrowers because they can lose decision-making power over their own investment opportunity. On the other hand, mezzanine debt is a safer option because although the borrower is subject to higher rates, even if the success of the project is brought into question, the owner maintains control of the property.
Mezzanine financing allows borrowers to meet their business goals by allowing them to secure the final drop of financing needed to meet their full goal. It also reduces the company’s need for equity, so the business owner does not dilute their own involvement and stake in the project. Mezzanine Debt also has a long maturity - if a company or project is intended for longer than five years, this tool is a great option and can allow for steady growth.
With mezzanine debt also serving as an additional layer of protection for lenders involved in a commercial real estate project, banks are more likely to provide capital. This disperses the risk amongst the capital stack, and with the flexibility often provided by mezzanine lenders, borrowers are able to expand their operations while retaining primary involvement.