What is Mezzanine financing or mezzanine debt?
Unlocking the power of mezzanine debt can be a valuable asset for any developer, allowing you to make full use of their capital resources. Yet negotiating favorable terms and understanding potential risks are key in crafting an advantageous deal that matches every investor’s risk appetite.
Mezzanine finance is a type of debt financing that is typically used by companies in the real estate, private equity, and venture capital industries. It is a form of capital that sits in between equity and senior debt in a company’s capital structure.
Mezzanine finance in real estate works by providing capital to a real estate developer or investor in exchange for a share in the ownership of the property or project. The mezzanine lender will typically provide financing to a developer or investor in the form of a loan that is secured by a second lien on the property. This means that in the event of a default, the mezzanine lender would be repaid after the senior lender, but before the equity holders.
Mezzanine financing is typically structured as either a loan or a combination of a loan and equity, such as preferred stock or warrants.
The key characteristic of mezzanine financing is that it is subordinated to senior debt in terms of priority for repayment in the event of a default.
Mezzanine financing can be used for a variety of purposes in real estate, such as to fund the acquisition of a property, to refinance existing debt, or to fund the construction or redevelopment of a property.
The terms of a mezzanine loan will vary depending on the specific deal, but it can include an interest rate that is higher than a traditional mortgage loan and a repayment period that is shorter.
Mezzanine financing can also include an equity component, such as an option for the mezzanine lender to convert the loan into an equity stake in the property or project.
Mezzanine financing is typically used in real estate as a way to add leverage to a project while keeping the equity stake of the developer or investor relatively low. It allows the developer to raise more capital for the project, but also brings in an additional investor with a higher interest rate.
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What is Mezzanine financing?
In real estate and project finance, mezzanine funding and mezzanine debt refer to the same type of financing. It is a hybrid of debt and equity used to finance the development and construction of a specific project.
This type of financing is typically used when a project’s cash flows need to be increased to cover the debt service on traditional bank loans or when the project’s sponsors wish to retain a higher percentage of equity.
Mezzanine debt in project finance is typically structured as a subordinate loan to senior debt, meaning that it is repaid after the senior debt has been paid off.
The word subordinate means that mezzanine debt is a second-ranking debt and that the mezzanine lender understands the rights and entitlements of the first-ranking (senior debt) lender to receive repayment of their debt in priority to the second-ranking mezzanine lender.
IMPORTANT: Not all senior lenders would agree to allow a subordinated debt position behind their securities in the capital stack.
The term Capital Stack is used to describe the various levels or tranches of capital equired to fund the cost of a project.
Mezzanine debt carries a higher interest rate than senior debt, as the lender is taking on more risk.
The lender may also have the option to convert the debt into equity in the project if certain conditions are not met.
Here’s how mezzanine finance works:
Let’s say you have a project where total costs or total uses of funds = $2m
You started this project thinking that you will be able to borrow 70% of the total costs and hence would only need 30% as equity.
However, when it was time get the construction loan, you realised that the market had changed now banks are only lending 60% of the Total Development Costs.
This is where mezzanine funding can help, because now instead of abandoning the project, you can bring another lender to fund the shortfall of 10%.
As it is clear from the example above, your main bank that will lend you 60%, is going to be your senior lender and when any money comes in, they will get paid out first.
Your mezzanine lender will be the junior debt or subordinate debt, as it gets paid afte the senior debt is paid out. And finally when both senior and junior debts are paid out, that’s when you get back your developers equity, as well as your profit.
- Senior debt is funding 60% of TDC i.e. $1,200,000 @ 6.5% / annum.
- Mezzanine debt is funding 10% of short fall i.e. $200,000
- Developers equity contribution - $600,000
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Who provides Mezzanine Financing?
Mezzanine funding in project finance often comes from institutional investors such as pension funds, insurance companies, or private equity firms.
They provide the funds for the property development project but take on a higher level of risk than traditional senior debt.
In return, they typically receive a higher return on their investment and may also have the option to convert their investment into equity in the project.
Why use Mezzanine financing?
There are several reasons to use mezzanine financing. It includes -
- Requirement for larger amounts
- It can be added to a standard loan, which helps to get more money.
- A less expensive and tax-friendly option to equity.
Are mezzanine loans secured?
A mezzanine loan is backed by a pledge of the company’s equity (like an LLC) that owns the mortgaged property.
If the mezzanine borrower doesn’t repay the loan, the mezzanine lender takes the property back and becomes the new owner.
The borrower’s real estate interests indirectly secure real estate mezzanine loans.
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