Obtaining financing can be an exciting but tricky endeavor. Part of the challenge in certain transactions is to figure out how to best stack the capital. Your client needs to decide whether to use mostly equity or mostly debt, or some combination of both, as well what the cost will be to achieve the desired return on investment.
There are alternative ways to structure a deal. One way is mezzanine financing, which is a hybrid of traditional debt and equity. Mezzanine financing is used by corporations for many purposes, such as expansions and leveraged buyouts, but it also is used in commercial real estate purchases.
Mezzanine financing bridges a funding gap. It is more expensive than traditional commercial mortgages, but it fills in the space between equity and debt. By obtaining a mezzanine loan, the principal investor won’t have to use as much of their own money to buy the property, and they can avoid bringing in more equity investors that might require even higher rates of return than those demanded by mezzanine lenders.
Purposes and features
Mezzanine financing is considered a hybrid of equity and debt in real estate deals because the lender has the option of converting the debt into equity should the loan default. Mezzanine lenders tend to be nonbanks seeking higher returns on their investments. These investors also can be pension funds, hedge funds or insurance companies, among others.
Mezzanine financing is used in concert with other types of debt and equity to buy various commercial real estate assets — including multifamily housing, offices, industrial and flex properties, and hotels. In most cases, these transactions involve existing assets, but the properties don’t necessarily have to be stable with high occupancy rates. Mezzanine financing, for example, is often used by an investor that is attempting to turn around a commercial real estate asset with the goal of selling it for a profit.
For stabilized properties, the borrower will need to show that the cash flows are sufficient to service the debt. The net cash flow after all operating expenses must at least be able to pay the debt, but in some cases, it must be at least 10% above break even. For transitional properties with low occupancy, your client will need to establish a plan to revitalize the property and convince the mezzanine lender that they have the means to execute that plan.
Mezzanine loan amounts will vary from $3 million to $30 million. Generally, a lender won’t consider a mezzanine loan with a balance less than $3 million. Although mezzanine financing is used in markets around the country, it is more commonly found in larger deals in top metro areas. The maximum leverage in a typical deal with mezzanine financing could be as much as 90% of the value of the asset, but the mezzanine portion will typically comprise a small slice of the debt.
If you have a $20 million project, for example, then the maximum debt in the deal might be $17 million, but only $3 million would be comprised of mezzanine financing. Interest rates for mezzanine loans typically range anywhere from 9% to 14%. Mezzanine lenders are assuming more risk than bondholders or conventional banks. In a bankruptcy situation, the mezzanine lender will typically be paid after the senior debt holders. As a result, the mezzanine lender typically demands a higher internal rate of return of anywhere from 12% to 14%, which will include profit participation or exit fees.
Most mezzanine financing will include interest-only payments. Term timelines for an outstanding loan can range anywhere from three to 10 years. The origination fees will range from 2% to 4% and can be provided upfront or when the mezzanine providers exit the project. For the most part, all mezzanine loans are nonrecourse for the borrowers. This means the individuals will not have to personally guarantee the loan, but they will need to sign a carve-out guarantor document that enables the lender to seek damages for certain bad acts by the borrower.
“ Although mezzanine financing is used in markets around the country, it is more commonly found in larger deals in top metro areas. ”
Getting prepared for a mezzanine loan approval is probably not as cumbersome as you might think. The best move is to first speak with a lender about the key elements of the deal.
Step one is to describe the location of the asset by using data and market research. You should point out the competitors in the area, and include maps and aerials in the description. Also pull together specifics on income levels, household demographics and any new developments in the area. For example, include information on any new major employer that might add jobs to an area, or any infrastructure improvements, such as freeway that might bring more traffic to your asset.
Next in line is to put together the background on the borrowers. The mezzanine lender will want to know that the principals have the expertise to pull this off. Include specifics on projects that they have previously completed. What expertise does your client bring to the table?
The third step is to briefly lay out the uses of the property and financial numbers that show cash flow. This is critical for making any traction, as the lender needs to see how they will be repaid. Your numbers should be explainable and transparent. Lenders will typically want to see cash flows that are significantly higher than the debt service.
The fourth step is the collateral details, such as the square footage and tenant information. Be as detailed as you can. Paint a picture of the site that includes the parcel numbers and assessor information. All of this will greatly enhance the lender’s confidence and ability to underwrite the mezzanine piece. The more specific your information, the higher probability your client’s project goes to the top of the pile.
Finally, you should present the highlights of the strategic plan. What makes this project more unique than others the lender is looking at? What steps has your client gone through to make the lender confident that you are a notch above the rest? You can gain a quick measure of the lender’s interest by presenting your plan. From there, you can take the next steps.
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In closing, it should be mentioned that mezzanine financing is not for everyone. There are many variables to consider that haven’t been touched upon here. The best place to start is to contact a commercial mortgage lender that has worked on these deals and understands the nuances.