What Are Mezzanine Loans?

By: Darin Ghaffari

An increasingly popular loan vehicle for commercial property, the mezzanine loan is similar to a second mortgage with a major variation.

Mezzanine Debt
Mezzanine Debt, ak.a Mezzanine Loan is a combination of debt and equity. It is a highest-risk form of debt but enjoys very god returns.

How mezzanine debt works;

1) There is a small hotel for sale.
The hotel generates an operating income of $2 million yearly and the asking price for the hotel is $10 million.

2) You don't have $10 million but only has $4 milion.
A lender is willing to finance it for $6 million at 8% interest yearly ($480,000). 

3) You opt for Mezzanine Debt and buys the hotel.
The senior lender contributes 6 million of debt financing and you contribute $4 million. Your ROI will be;

  • Hotel generates - $2 milion yearly
  • Less 8% interest - $480,000
  • Profit before tax -  $1.52 million
  • Add 35% corporate tax - Hotel earns $988,000

4) You now have a business that generates free cash flow of $988,000 yearly, using $4 million of your money. 

In short, a mezzanine debt is use in a buyout to displace some of the capital that would usually be invested by an equity investor. So rather than being secured by the actual cash, mezzanine debt are secured by the stock that is held by the company that owns the real estate. The real estate itself has already been used to secure the first, or primary loan. 

What Happens When Mezzanine Debt Defaults
If the company fails to make timely payments on their mezzanine loan, the lender can foreclose on the property, seizing the stock. If the lender has control of the stock, the lender has control of the company and of the property or real estate. In fact, foreclosing on a loan that is secured by stock is much easier than foreclosing on a loan that is secured by real estate property.

If the loan holder defaults on the mezzanine loan, the lender can take over the stock of the company. This means that the lender can sell the property although it would still have to pay off or satisfy the initial mortgage. This strategy provides a streamlined foreclosure that takes much less time than the standard foreclosure on a mortgage.

Why would someone need to get a mezzanine loan rather than a conventional second mortgage? In many cases, the terms of the first loan preclude subsequent liens or second mortgages on the property. Hence, the mezzanine loan comes into play since it does not involve the actual real estate holding. It allows the borrower to have access to additional funds that would not be available otherwise.

Typically, a mezzanine loan is one that is acquired for a large project such as an office tower, large shopping center, shopping mall, large hotel, apartment complex, or industrial park. Mezzanine loans are large loans that cover millions of dollars of debt. In fact, mezzanine lenders are often quite specialized in the specific type of loans that they offer. Therefore, it might be necessary to search for a lender specializing in loans for the specific venture that you are in.

The first mortgage always takes precedence and the mezzanine loan always takes second place. For the borrower, one of the advantages is the ability to secure additional funds without the use of the property as security. The borrower can meet financial goals with the additional dollars provided by mezzanine loans. This would not be possible with conventional loans due to the terms arranged in the first mortgage.

One of the advantages for the lender is the ability to foreclose at a quicker pace should the need arise. The mezzanine loan is a form of junior financing that has no claim whatsoever on the underlying real estate or property. The company or partners in the project pledge their interest holdings or stock as security. The interest of all holders must typically be pledged to the lender of the mezzanine loan. This practice guarantees that the lender will acquire full control of the stock or interest in the project should the loan default. Partial control could inhibit the ability to sell the property in order to realize the repayment of the loan.

Mezzanine debt can be short term, long term, fixed rate, floating rate, amortized, or standing. In most cases, they are short term, interest-only, and floating rate loan transactions. Additionally, this type of loan is generally used to borrow millions of dollars.

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