The term mezzanine finance can be complicated. Mezzanine financing in commercial properties gives lenders the authority to convert debt into equity if a borrower defaults on a payment.
To give you a better example of this would be, if the borrower fails to pay the debt on time, the lender then can take action by taking an amount of the investment property. They can then sell a part of it to pay off their debt owed. Mezzanine financing can be useful for both first-time commercial real estate property investors. Seasoned investors can also enjoy the benefit of Mezzanine financing as a way to increase their property portfolio. Mezzanine financing is beneficial for those who don’t have enough funds to do so. Mezzanine finance loans typically run from 1-5-year terms, although some loans can go up to 10 years. Also, mezzanine loans are usually interest-only.
How mezzanine finance works?
Part of the reason why the term mezzanine is complicated is that it is a kind of catch-all for an entire category of mortgage debt types — also used for non-common equity instruments that are filling in a capitalisation gap between them.
Mezzanine, which means middle is a financing term that can take the form of debt or equity, more but more specifically:
- Preferred equity
- Junior debt includes things such as a second mortgage
- Participating debt
- Convertible debt
Senior mortgage debt is secured legally. It can also be collateralised, by a physical property and then associated with cash flows. Then the rights to keep the property until the debt is paid on the property in question. The debt is then recorded with the government to certify a legal relationship.
In all cases, the mezzanine finance option is classed as senior debt, and in almost all cases, mezzanine finance is not secured by the property. Instead, it is secured by the equity of the company or person that owns the investment in the asset. So, the mezzanine position is always a riskier one to be in. For this reason, the cost of what you pay for mezzanine capital is higher than that of senior mortgage debt.
How is mezzanine finance modelled?
For property developments, the mezzanine finance will be used before the primary construction loan. Then it will be repaid. But only once the original construction loan is repaid in full. Your sources of funds have to reflect this priority of funding and the lack of priority when it comes to paying back.
For purchases and assuming all the loans close at the same time, you do not have to worry about the priority.
If the mezzanine financing takes the form of preferred equity, the funding depends on the joint venture operating arrangement between the mezzanine investor and the property equity backers. The preferred shares will provide the holders of the shares some set of named rights above the rights of the common equity. It will be subordinate to the senior debt. One example means that the preferred equity will engage in a priority preferred return, whereas the common equity doesn’t.
Convertible debt provides the debt with the option to convert into common equity at specific terms.
The main benefit of a mezzanine finance loan.
One of the most significant advantages of mezzanine finance is that you can use a flexible financing plan. Also, you have a low probability that the owner will lose ownership or complete control of the property.
Mezzanine finance does not usually require the same amount of due diligence. Meaning Mezzanine finance is generally quicker to achieve a response from the provider rather than other types of loans.
Mezzanine finance is also growing in popularity. Many agencies and lenders have introduced the service to their product portfolio. They have done this to encourage borrowers and also to help keep properties more affordable. Some of these companies don’t have their own mezzanine products, but they do allow using mezzanine finance for buyers in a variety of different circumstances.
For a commercial property developer who needs more funds to build or even to finance a new project, preferred equity is beginning to increase in popularity as an alternative to mezzanine financing. But unlike mezzanine financing, which is classed as debt with an equity conversion option, preferred equity gives the investor a direct stake into the project. So usually, preferred equity gives an external investor a fixed rate of return.
Preferred equity investors don’t possess any rights of ownership against the property, and, unlike first position lenders, they don’t have any rights of ownership against the property. For this reason, preferred equity investment becomes riskier than a mezzanine loan. But, many equity investors have what is called an “equity kicker”. An equity kicker is an additional equity incentive, and this allows them to take part in a project’s gains if the property reaches its expected potential.
Mezzanine finance Prepayment Penalties
The same as other kinds of commercial loans, mezzanine finance typically involves a prepayment penalty. So if a borrower tries to pay off their loan early, they will incur charges. Mezzanine finance does not usually have long lock-out periods. Prepayment still can be expensive, as most finance providers need their borrowers to pay yield maintenance. Yield maintenance allows the investors to maintain the same amount of yield they would if the borrower had made the early prepayment.
DISCLAIMER: These articles are for information only and should not be construed as advice. You should always seek advice prior to taking any action.