Mezzanine loans are a type of financing that effectively allow borrowers to achieve a higher loan-to-value ratio than typically available with conventional loans. In commercial real estate, mezzanine loans enable borrowers to make up the difference between their equity investment and the senior debt that lenders like banks or credit unions provide.
Mezzanine loans are an increasingly popular financing option for businesses seeking to raise capital in a cost-effective way. They can provide the funds needed to pursue growth opportunities while preserving equity and avoiding dilution of ownership interests. Before you decide if this type of loan is right for your business, it’s essential to understand how mezzanine loans work and their advantages and disadvantages. We’ll show you everything you need to know about mezzanine loans so you can decide whether they’re the right choice for your business
What Is a Mezzanine Loan?
A mezzanine loan is a form of financing that bridges the gap between equity and debt. It combines elements of both to provide funding for businesses with limited access to traditional bank loans or venture capital. Mezzanine loans can range from $500,000 to $50 million, depending on the size and complexity of the project or company.
A mezzanine loan is an additional debt taken on by the borrower on top of a conventional loan to finance a commercial real estate acquisition or expansion project. Mezzanine loans reduce the amount of equity borrowers need to commit to purchase a building or property.
How Mezzanine Financing Works
Mezzanine financing gives businesses access to capital that is not available from traditional loan sources. This type of financing is particularly popular among developers, with mezzanine lenders providing additional debt financing—above the loan-to-value limits of most conventional loans—in exchange for equity or a portion of future profits. Loan terms are usually structured as a hybrid between debt and equity. In some cases, borrowers can even use mezzanine financing to purchase additional assets for the business.
Mezzanine loans typically aren’t secured by a lien on the financed property, but they may be collateralized by a lien on the borrower’s other assets or personal guarantees. Due to their higher risk profile and lack of collateral, these loans are generally more expensive than senior debt, which is often secured. Instead, the lender usually takes an equity stake in the business and may receive a higher rate of return if the company is successful. However, the cost of this type of debt is typically lower than what would be required by an additional equity investor who contributed cash to a project.
Mezzanine financing typically has specific characteristics:
- It’s subordinate to senior debt, but it has priority over preferred and common equity. In the case of bankruptcy, this capital structure determines which creditors get paid first.
- It typically comes with a higher interest rate than senior debt.
- It’s typically not secured by the subject property.
- Mezzanine financing is often structured as an interest-only loan, as opposed to being amortized over the life of the loan.
- Mezzanine financing often has a shorter duration than secured debt.
Mezzanine use cases
Mezzanine loans are most often used for the acquisition or refinance of an investment property. They can be an excellent option for first-time commercial real estate investors who may not have enough cash to cover a 20% down payment and improvement costs. Additionally, mezzanine loans can be good for borrowers looking to expand their holdings without committing all their cash on hand.
Whether you’re an experienced investor or just dipping your feet into the commercial real estate world, mezzanine loans can close the gap to finance your property, in addition to a loan from a conventional bank or financing company.
Pros and Cons of Mezzanine Loans
Mezzanine loans can be an excellent option for businesses that need access to quick funding to extra funding above what they can qualify for with traditional bank loans or financing companies. Although they are typically more expensive than senior debt, these loans offer more flexible repayment terms and less paperwork than traditional loans. However, it’s important to carefully weigh the pros and cons of mezzanine loans before deciding.
Mezzanine loans can provide businesses with a significant source of capital that might otherwise be difficult to obtain. They are often easier to qualify for than traditional bank loans, require less paperwork, and offer more flexible repayment terms. These are some of the main advantages of mezzanine loans:
- Can complete financing. Mezzanine loans can be a great way to bridge the gap between your secured debt and the final cost of your commercial property. Additionally, mezzanine lenders are typically willing to take on riskier projects as they have an equity stake in the company’s success.
- Reduce equity requirements. Even if you do have the capital to avoid taking out a mezzanine loan, you might still want to take one out to keep your capital free. For instance, you might be closing multiple real estate deals at the same time, and you might not be able to afford to sink a high amount of equity into one of the projects. In that case, a mezzanine loan would be a great solution to complete the deal.
- Protect ownership interests. Mezzanine loans can help businesses avoid diluting their ownership interests by minimizing the need for external equity financing.
- Often provide flexible financing. These loans also provide a flexible financing option for borrowers and investors who want to keep their capital free, or who don’t possess the financial liquidity to sink a huge amount of cash into their property.
- Close quickly. Mezzanine loans typically require less due diligence than other loans from banks and credit unions. That means they often close quickly, often within a period of 10 to 15 business days.
That said, mezzanine loans come with some disadvantages—especially when it comes to borrowing costs. Here’s what you need to know about the disadvantages of using mezzanine loans:
- May be limited to established businesses. Mezzanine loans are sometimes only available to businesses that have an established track record of success or have secure cash flows and assets as collateral.
- Come with higher interest rates. Because the borrower doesn’t need to post collateral, mezzanine loans present a higher risk to lenders than the risks presented by senior debt. The additional risk leads to higher interest rates—often between 10% and 20%—and the presence of more covenants.
- May include restrictions. Lenders may impose restrictions on how the money is used and may require additional equity financing if the loan amount is not enough to cover all costs. For example, covenants might include restrictions on taking equity out of the property or prohibitions on obtaining additional financing until the entire mezzanine loan has been repaid.
- Prepayment penalties may apply. Mezzanine commercial real estate loans also include prepayment penalties if borrowers attempt to pay off their loans early. Because these prepayment penalties are often expensive, they should be considered before finalizing a mezzanine loan.
Mezzanine Loan Costs
The cost of a mezzanine loan is primarily determined by the lender’s risk assessment, which considers factors such as the borrower’s creditworthiness and cash flow. In general, borrowers pay interest on their loans at a rate between 10% and 20%. They may also be required to cover specific fees associated with obtaining the loan. These can include origination fees, legal/accounting costs, and due diligence costs.
In addition to these upfront costs, many lenders require equity investment from the borrower in exchange for the loan amount. The equity that is given up in exchange for financing with a mezzanine loan is called “equity cushion” or “equity kicker.” This equity cushion is typically equal to a percentage of the loan amount and can range from 5% to 15%, depending on the borrower’s financial situation.
It is also important to note that mezzanine loans often include prepayment penalties, which means that if the borrower attempts to pay off their loan in full before it reaches maturity, they may be subject to high interest rates or other costs.
Here’s what a mezzanine financing loan term sheet might look like for a commercial property loan:
- Amount: $1.5M
- Term: Coterminous with the first (5 years)
- Interest Rate: 14% interest-only
- Origination Fee: 4.5%
- Maximum LTC: 85%
Mezzanine Loan Rates
|Term||Fixed-rate||Floating rate||Max LTV||Max amortization|
|5 years||5.24% to 8.24%||N/A||75% investment||30 years|
|7 years||5.91% to 8.91%||N/A||75% investment||30 years|
|10 years||6.56% to 9.56%||N/A||75% investment||30 years|
Mezzanine Financing Example
Consider a real estate investor who wants to purchase a commercial property for $4M with an LTV of 65% ($2.6M) and needs to borrow the remaining $1.6M. In this case, they could use a mezzanine loan for the additional funds. The loan would be structured such that the borrower pays interest-only payments at 12% over 10 years with no amortization or prepayment penalty. The lender provides the full amount of capital with no need for further equity contributions from the borrower unless required by certain covenants in the agreement.
Mezzanine Loan Alternatives
If the cost of a mezzanine loan is too high, there are other financing options you can explore.
- Senior debt financing. This type of loan allows borrowers to finance up to 80% or even 90% of their project costs with lower interest rates and more flexible repayment terms than mezzanine loans.
- Joint venture equity. Joint venture equity involves partnering with an investor who provides capital in exchange for ownership rights to the property.
- Equity infusion. If you have enough cash available, consider an equity infusion instead of taking out a loan. Equity infusions allow you to own 100% of your investment without paying any loan fees or interest payments.
All told, mezzanine financing can be a powerful tool for businesses looking to bridge their funding gap between traditional debt financing and equity financing. Mezzanine lenders generally require higher interest rates than traditional debt lenders. Still, they may offer more flexible terms and greater flexibility regarding how money is used.