Mezzanine loans form subordinated debt that sits between the senior lender and equity investor in the capital stack. Mezz also has a blend 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 be 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
Mezzanine returns are a step lower than equity as the lender is protected with the equity capital in the capital stack. The mezzanine loan’s return profile is weighted towards interest, but depending on the negotiated outcome, profit participation can also be included.
Mezz Interest Format
Given the capital stack position of Mezz being behind the senior loan, the interest schedule is interest only with no 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 a 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 a form of leverage to juice returns.
Security Interest and Facility Documentation
The security for the loan can either in the form of a secured second mortgage behind the senior financier or in an unsecured form but security over the holding structure. By holding security, interest provides the Mezz lender a seat a the table in the bankruptcy process.
Ideally, the mezzanine facility documentation is drafted consistently with the senior loan to ensure no inconsistency in the default or cross-default provisions. The main difference will be the covenant clauses that reflect the commercial agreement between the Mezz lender and the borrower. For Mezz loans, it is generally drafted more loosely than senior loans to reflect the instrument’s riskiness (and return).
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 can act and protect each party’s rights in a default scenario.
The key points covered in the intercreditor agreements include:
- Permissible payments regime to ensure the borrower can pay the interest under the Mezz debt
- Standstill periods cover the timeframe the senior is allowed to act exclusively before 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 control any changes to the amount and terms of the prior ranking debt.
Where Does Mezzanine Debt Sit in The Capital Structure
The example below shows the difference between the 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 to generate cash flow.
Therefore it is usually out of the retail investors’ realm as the minimum starting point should be $2 million. If you extrapolate that into a specific position in the capital stack, the property’s underlying value should start at $10 million.
We are not saying small investors shouldn’t or can’t use Mezz at a lower level. Still, the cost without scale will be prohibitive as at that stage. The loan will require lawyers to draw up the loan documentation and, more importantly, the senior lenders inter creditor agreement.
For smaller real estate investors, the key hurdle in securing a Mezz loan is the agreement with the senior financer. They do not like the deal’s increased complexity from their perspective as the deal size is 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:
- Minimizing equity capital required could enable the 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, 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 real estate investment risk profile, it could still be cheaper than equity.