Mezzanine loans are a form of subordinate debt which sits between the senior lender and equity investor in the capital stack. In terms of risk and returns, mezz also has a blended of debt and equity hence it is provided by both real estate equity and debt funds. The usage of Mezz is part of an advanced strategy investing in real estate and not designed for everyone. It can a useful tool to leverage equity returns in real estate for those that know what they are doing.
Senior vs Mezz Loan
Mezz Return Profile
Returns from Mezzanine is a step lower than equity as the lender is protected with the equity capital in the capital stack. The return profile is mostly weighted towards interest but depending on negotiated outcome it could come in form of profit participation.
Mezz Interest Format
Given the position in the capital stack behind the senior loan the Mezz facility is typically interest only with not amortization. The interest can also be paid current (monthly or quarterly) or capitalized called payment in kind “PIK” where it is added to the loan balance and repaid at loan maturity.
Who Are the Largest Users Mezz Debt?
Blue chip real asset investors like listed REITs don’t typically use mezzanine loan in the capital stack due to their lower risk profile. Private investors, family offices or real estate private equity funds would use Mezz as form of leverage to juice returns.
Security Interest and Facility Documentation
The security for the loan can either in the form of secured second mortgage behind the senior financier or in an unsecured form but security over the holding structure. By holding a security interest provides the Mezz lender a seat a the table in the bankruptcy process.
Ideally the mezzanine facility documentation is drafted in consistency with the senior loan to ensure there is no inconsistency in the default or cross default provisions. The main difference will be the covenant clauses which reflect the commercial agreement between the mezz lender and the borrower and it is generally drafted more loosely than senior loan to reflect the riskiness (and return) of the instrument.
Mezz and Senior Loan Intercreditor Agreement
Finally, the key document will be the intercreditor agreement between the senior lender and the mezz lender. This document will set out the terms and steps in how the mezz lender is able to act and the protection of each party’s right in a default scenario.
The key points of covered in the intercreditor agreements include:
- Permissible payments regiem to ensure borrower can pay the interest under the mezz debt
- Standstill periods which covers the timeframe the senior is allowed to act exclusively prior to the mezz lender stepping in to take control of the assets in the event of default
- Variation principal of the senior documents. This is important for the mezz lender to ensure the any increase in prior ranking debt is controlled or limited and interest variation of the senior debt to ensure there is cashflow for the mezz lender.
Where Does Mezzanine Debt Sit in The Capital Structure
The example below shows the difference between traditional and leveraged capital stack.
How much does Mezzanine Debt Cost
Since these are bespoke loan agreements, pricing or interest rate is dependent on project specific risk (real estate development or leasing risk) and the degree of leverage required.
Typically the loan sits between 50% to 75% LVR and interest can be higher if the property is generating cash flow or visibility that it will generate cash flow.
Therefore it is usually out of the realm of the retail investors as minimum starting point should be $2 million and if you extrapolate that into a typical position in the capital stack, the underlying value of the property should start at $10 million.
We are not saying small investors shouldn’t or can’t use mezz at a lower level but the cost without scale will be prohibitive as that stage the loan will require lawyers to draw up the loan documentation and more importantly the inter creditor agreement with the senior lender.
For smaller real estate investors the key hurdle in securing mezz loan is the agreement with the senior financer. They do not like the increased complexity of the deal from their perspective as the deal size are not large enough to worth the effort.
Why Do Investors Use Mezz Debt?
The best way to think about the cost from the equity perspective is it should be in the context of a blended cost between the senior and subordinated loan.
Some of the reasons investors might look to borrow mezzanine debt include:
- Minimise equity capital required – this could enable investor to stretch to acquire the asset or capital is being tied up elsewhere when the investment opportunity arose
- Leverage equity return – since there is more debt in the capital structure naturally the return on the equity is higher but with greater risk
- Attractive Cost vs opportunity cost – even if mezz is high single digit or low double digit returns depending on the risk profile of the real estate investment it could still be cheaper than equity