Commercial real estate has always been popular due to its attractive risk-reward profiles. To jump in a venture, most estate investors choose to finance their investments with a cash down payment and a conventional mortgage. However, many big ideas require securing large funds that can not always be met with typical financial instruments. So what can help investors bring those ideas to life? Two words: mezzanine debt. But what exactly does this financial instrument mean?
Mezzanine debt helps commercial real estate investors bridge the gap between their equity and the senior debt a lender will provide them. At the same time, it gives them the possibility to earn a higher return rate on their investment. Now, let us see in-depth what benefits mezzanine financing can offer to investors to secure their next real estate adventure.
Characteristics and Benefits of Mezzanine Debt: The first characteristic and, at the same time, the main benefit of mezzanine debt is that it is an additional debt an investor takes on to finance a commercial real estate venture. With its help, they can reduce the amount of needed equity when fixing together funding for an acquisition or expansion project.
In the real estate capital stack of an investment, the mezzanine debt comes right above senior debt. It is usually in the form of subordinated debt; however, it can have an equity component. This subordination means that it gets paid after all senior debts have been settled. Nevertheless, it has priority over preferred and common equity in the event of bankruptcy. Once the senior debt and operating expenses are paid, all income must go to pay the mezzanine debt next. If payments are not met, the mezzanine financing lender has the right to seize out the equity position and potentially take over the property and the mortgage.
Even though the mezzanine financing has a higher interest rate than senior debt, an investor can earn a higher return rate with this instrument. The return often goes between 12% and 20% a year. Naturally, that depends on the project’s risk and how much equity the sponsors are bringing in.
Lastly, another really important benefit that mezzanine financing offers is the reduction in the equity requirement. An investor does not have to use all the equity just for one deal. They can take the loan and use the rest of the equity for another opportunity, further leveraging their returns. In another case, the mezzanine loan can assist those who do not have enough capital but still do not want to miss an opportunity. This way, they do not have to bring on other equity financing partners and dilute their ownership interest.
How Can Investors Benefit Considerably from Mezzanine Financing? As we have seen, mezzanine debt works to fill the hole between the senior debt financing available to fund a real estate deal and the equity investors have put into the transaction. Now, let us translate that into a real-life scenario…
In a conventional real estate transaction, an investor can usually cover the senior debt for up to max 80% of a property’s value. That leaves 20% that need to be covered with equity (cash on hand). For example, an investor likes to buy commercial real estate with a purchase price of 1 million dollars. The investor can get $600,000 in financing for a senior lender’s purchase, leaving them in need of $400,000 as additional capital to close the deal. Suppose this investor does not have (or in many situations does not want to lock such a significant amount of money) $400,000 in capital to commit to this deal. In that case, they will need to consider alternative funding options.
Let us look at the three most common plots: The first is to bring on other equity investors, meaning equity dilution and a lower amount of control from the borrower’s side on the property. Not a preferred option for many experienced investors. The second is finding some other funding source, such as preferred equity. However, the private lender will prioritise repayment from any cash flow or profit earned from the investment. Also, it does not sound like an excellent choice.
The third and best option would be mezzanine financing. The investor can obtain $200,000 in mezzanine financing and give the other $200,000 cash on hand. Using this financial instrument, the investor would reduce their equity financing requirement while boosting the investment return and showing a higher-end profit. What is more, mezzanine loans typically do not require payment during the debt term, only at the end of it, enabling the investor to improve their cash flow.
Is Mezzanine Financing Good for Every Deal? When investing in commercial real estate, investors should be aware of the mezzanine loans’ advantages and the benefits they provide. Assessing all options and financial instruments is necessary in order to obtain a maximum gain of any potential real estate venture.
Nevertheless, mezzanine financing offers a great way to cover the difference between the equity investors have to put into a deal and the senior debt financing secured from lenders. And even though these loans increase the deal’s risk profile, they also enhance the return potential. Ultimately, the best way to decide whether a mezzanine debt is the best option for a particular deal is by weighing the pros and cons of utilising this financing tool in the special real estate venture.