In residential real estate, homeowners typically rely on two types of financing. On the equity side, owners contribute their own capital for a down payment. On the debt side, they use some sort of permanent mortgage (e.g. conventional, FHA, VA, etc.). With commercial real estate, far more financing options exist, and developers and investors alike should have a solid grasp of each one. In this article, we’ll discuss mezzanine loans in commercial real estate.
Specifically, we’ll cover the following topics:
- An Overview of the Commercial Real Estate Capital Stack
- Pros and Cons of Mezzanine Loans
- Final Thoughts
An Overview of the Commercial Real Estate Capital Stack
Prior to reviewing mezzanine loans, we need to cover the capital stack, in general. In commercial real estate, investors typically need multiple funding sources to make a deal happen. A deal’s capital stack refers to the specific composition of these different sources.
It helps to visualize a capital stack as a literal stack. On the top of the stack, you have the common equity. These are the funds that command the highest returns, but they also include the most risk. If a deal goes south, the common equity holders are the last to have their investment returned.
At the bottom of the capital stack, you have the senior debt. This is the first position mortgage loan. That is, the loan is actually secured by the underlying real estate. Accordingly, if the deal falls apart, the senior debt holder receives its cash back before anyone. As such, this capital has the lowest risk, but it also offers the lowest returns. While common equity investors may receive 15% or greater returns on their investments, senior debt (depending on market conditions) falls more in the 3% to 6% range.
A variety of financing options exist between common equity and senior debt (e.g. junior debt, preferred equity, and mezzanine loans). From a visualization perspective, the “higher” you go on the capital stack, the greater your potential returns and risk. In addition to several other options, mezzanine loans bridge the gap between common equity capital and the senior mortgage to make a deal happen.
In the next section, we’ll provide an overview, pros, and cons of mezzanine loans from both an investor’s and developer’s perspective.
Pros and Cons of Mezzanine Loans
Overview
Mezzanine loans 1) fall between common equity and senior debt on the capital stack, and 2) serve as a way to fund the gap between these two financing sources. As a type of debt financing, mezzanine lenders actually hold a lien on the property. Frequently, this debt takes the second position mortgage. This means that, in the event of bankruptcy, the mezzanine debt holders will have their capital returned immediately following the senior debt.
Pros – Investors
Mezzanine debt offers investors higher returns than a first position mortgage, making this a particularly attractive investment in low-interest-rate environments. And, as a form of debt, this financing source also offers investors more security than any equity investments. If the deal collapses, mezzanine debt holders will recoup their capital prior to any equity investor.
Cons – Investors
What mezzanine debt gains in security it sacrifices in upside. Yes, mezzanine debt commands higher returns than senior debt. But, in many instances, these debt terms include a fixed rate. For instance, a mezzanine debt note may call for 6% returns over a five-year term. If the deal generates 20% returns, though, the mezzanine debt holders don’t collect any of that upside performance.
Pros – Developers
In many commercial deals, senior debt lenders cap their loans at a certain loan-to-value. For instance, with 70% loan-to-value terms on a $20 million deal, developers can secure a maximum permanent mortgage of $14 million, leaving a $6 million cash gap. To fill that cash gap, developers can A) add their own capital, B) bring in outside equity investors, C) secure a mezzanine loan, or D) use some combination of all three options. Mezzanine loans allow developers to make a deal happen without diluting a deal’s equity via outside investors which, in theory, increases overall return on equity.
Cons – Developers
Continuing the above example, a mezzanine loan may provide a way to bridge a deal’s cash gap. But, this financing solution will come at a cost. As a second position lienholder (i.e. junior to the permanent mortgage), the mezzanine debt holder will be exposed to more risk. Accordingly, they will charge a higher interest rate than the permanent lender, increasing a deal’s debt service. And, as a debt financing source, mezzanine loan payments need to be paid regularly, regardless of a deal’s performance (as opposed to most equity financing options). This regular payment requirement can significantly increase a developer’s risk of default.
Furthermore, most permanent mortgage lenders impose a maximum debt service coverage ratio (DSCR) covenant. DSCR equals a project’s net operating income (NOI) over its debt service (i.e. principal and interest), essentially providing lenders an operating income buffer to ensure debt payments will be made. And, these lenders generally include all debt service, meaning mezzanine loan payments will be factored into the DSCR calculation. Unless a deal has extremely healthy NOI, these additional loan payments may breach a permanent mortgage lender’s DSCR covenant.
NOTE: Some mezzanine debt is structured as a hybrid instrument, allowing holders an option to convert their debt into equity in certain situations.
Final Thoughts on Mezzanine Loans
From both an investor’s and developer’s perspective, mezzanine loans have advantages and disadvantages. Depending on your unique situation and the specific deal, pursuing this financing option may or may not make sense. For investors, mezzanine loans offer higher returns than senior debt while providing more protection than equity stakes. For developers, these loans may allow you to finance a project without diluting the deal’s equity – albeit at a higher cost than senior debt.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.