Buying commercial real estate is an excellent investment since it typically generates higher returns than residential property. It also comes along with other benefits such as for example, longer leases. However, these purchases also attain their complexity and higher risks, especially when looking at financing the asset.
Financing a commercial real estate purchase is a daunting process, especially when you have already found a traditional, first-position commercial real estate loan, but you still lack money to close the deal. The gap between what lenders will provide and what borrowers want from debt sources can be successfully bridged with mezzanine financing.
So, if you want to know more, read on. This article will outline everything you need to know as a borrower about mezzanine loans for commercial real estate.
What is a Mezzanine loan for commercial property?
Mezzanine loans are a creative financing approach that combines debt and equity financing to help investors purchase commercial real estate. Mortgage lenders, such as commercial banks or pension funds, usually offer a mortgage between 50 to 75 percent of the property value. A mezzanine loan is used to reduce the amount of money the buyer needs to complete the purchase. However, mezzanine loans can also assist when improving or renovating commercial properties. Once the work is completed, the loan is replaced by a new first mortgage based on the property's higher value.
Let us give you an example. Suppose a business wants to buy a 100 million dollar property. A senior lender may only want to lend as high as 75% of the value ($75 million). The business does not have all the needed $25 million on its own, so it finds a mezzanine investor to invest $10 million.
Where do mezzanine loans stand in multi-leveled financing?
In a situation where there is multi-level financing for commercial real estate, the money sources are scaled in the following order: senior debt, mezzanine debt, and the owner's equity. This scale is not random. The senior mortgage has legal (and cash flow distribution to parties) priority over all other financing forms. That means that the mezzanine debt is subordinate to the senior mortgage but has a higher priority than the equity portion. In case of a default, the mezzanine lenders have the right to convert their loan into equity (through a previously written warrant) at a predetermined price per share if the borrower doesn’t pay the loan on time or in full. This right comes into effect naturally, only after other senior debts are paid off.
What are the mezzanine loans characteristics?
Mezzanine loans for financing commercial real estate have some specific traits for the way they are structured.
● Have a higher interest rate than senior debt (between 10-20%).
● They offer a fixed part of the return, which makes them less weak than general or common equity.
● They provide no principal amortization and are more often unsecured, and with a higher yield than senior debts.
● As already pointed out, they are subordinate to senior debt and senior to common equity debts.
What are the advantages for borrowers of using a mezzanine loan?
There are a few advantages why borrowers would consider a mezzanine loan as part of the capital required for the financing of commercial real estate:
1) Reducing the amount of needed equity. One of the most important benefits mezzanine loans offer is the reduction of the amount of equity required to fund the purchase, renovation, or expansion of a commercial real estate project. For example, suppose a borrower does not have enough equity to purchase a property. Rather than miss an opportunity, they can choose between two options. The first is pursuing a mezzanine loan to bridge the hole between the amount of equity they have and the amount of equity they need to purchase the property. The second (less attractive option) is to bring in additional investors to supply the required remaining equity. This scenario will bring to equity dilution and usually a lower amount of control from the borrower's side on the property.
2) Boosting equity returns. The less equity a borrower uses for a property, the higher their returns will be. So, instead of trading a large amount of equity for capital, borrowers can minimize their equity dilution while borrowing more than traditional banks want to lend. For example, an investor can use their remaining equity for another deal, which would further leverage their returns.
3) Flexible financing. Mezzanine loans are usually offered with a tailor-made approach in mind. That means that they provide a large space for maneuver in shaping amortization schedules, agreeing on the borrowing rules, or specifying special conditions for repayment. Furthermore, these loans typically do not require a lot of due diligence. The borrower also does not need to present an asset to take the loan, so it is feasible to close more quickly than other loan types.
4) Various repayment options. Mezzanine lenders can include different features as repayment options. Borrowers can pay interest charges with cash, add them to the loan balance, or use equity-like instruments to pay the lender. They can also use, for example, PIK toggles, which allow the borrower to "pay" its interest payments in forms other than cash. Suppose the company can not make an interest payment as scheduled. In that case, it can postpone some or all of the interest for some time.
Mezzanine loans are a necessary funding tool for real estate investors. They are an excellent option for closing the gaps after an initial lender has contributed a loan. It frees the borrowers' funds or adds up when the borrower is short of affording the real estate purchase. And though their interest rates are high, mezzanine loans result in less money out of the investors' pocket and an increase in equity return.
To decide whether the mezzanine loan is appropriate for a specific investment, hire an analyst who will construct detailed financial models and help you understand all the benefits and weaknesses of the particular financial structure.