A real estate mezzanine loan, often known as mezzanine financing, is one of the several sources of capital available to investors. Mezzanine loans provide capital in the form of subordinated debt to investors or borrowers. This covers every detail of this kind of loan including examples, importance, and how to go about it.
What Is Mezzanine Financing and How Does It Work?
Mezzanine financing is a mix of debt and equity financing that offers the lender the opportunity to convert the loan into an equity interest in the company in the event of default— usually after the senior lenders have been paid. There is a risk difference between senior debt and equity in terms of risk.
Basically, equity instruments are integrated with mezzanine debt. Attached to the subordinated debt are warrants, which boost the value of the loan and provide more flexibility when dealing with bondholders.
Mezzanine finance is typically related to acquisitions and buyouts, and it can be utilized to give new owners priority over existing owners in the event of bankruptcy.
What is a Commercial Real Estate Mezzanine Loan?
A mezzanine loan is a type of finance used by investors to fund purchases or development projects in real estate. Within the capital stack, mezzanine loans are subordinate to senior debt, although they have precedence over both preferred and common equity.
Building mezzanines, which are one level above the ground floor, are the inspiration for these loans.
Furthermore, investors can employ mezzanine loans to bridge the gap when senior financing doesn’t cover the cost of an acquisition or development project.
By providing additional money without selling the maximum number of shares, mezzanine bridge loans enable investors to increase their return on investment.
However, real estate mezzanine loans are unsecured, which means they don’t require physical collateral because they combine debt and equity financing.
Meanwhile, lenders can collect their interest returns in the form of equity instruments if a borrower defaults or files for bankruptcy.
How Does It Work in Businesses?
Mezzanine finance bridges the gap between debt and equity financing, literally. It is also one of the riskiest types of debt. It has priority over pure equity but is below pure debt. However, when compared to other loan kinds, it gives some of the best returns to debt investors, with rates ranging from 12 percent to 20 percent per year, and occasionally as high as 30 percent.
But because mezzanine financing carries a higher interest rate than the senior debt that companies would typically receive through their banks, and is significantly less expensive than equity in terms of the overall cost of capital, it can be thought of as either highly expensive debt or cheaper equity. It also reduces the value of the company’s stock.
Finally, mezzanine finance allows a company to raise additional cash and boost its return on equity.
On the other hand, Mezzanine loans/financing can be used by businesses to support specific growth projects or to assist with acquisitions with short- to medium-term time horizons.
These loans are frequently funded by the company’s long-term investors and existing capital providers. There is no duty to repay the money obtained through equity financing in the case of preferred equity. The company has more liquid funds available for investing in the business because there are no mandated payments to make. A mezzanine loan involves only interest payments prior to maturity, allowing the firm owner to have more free capital.
A variety of traits are common in mezzanine loan structuring, including:
- Senior debt is subordinated to mezzanine loans, which have priority over both preferred and common stock.
- They have higher returns than regular loans.
- Oftentimes, these are unsecured debts.
- The principal of the loan is not amortized.
- They can be set up with a combination of fixed and variable interest rates.
Benefits of Mezzanine Financing for Investors and Lenders
Real estate mezzanine loans have potential benefits regardless of which side of the transaction you’re on. This breakdown examines how the form of a mezzanine loan might help investors seeking financing as well as the possible benefits for lenders supplying the capital.
For Commercial Real Estate Property Buyers & Investors
In a pinch, real estate mezzanine loans can be a useful instrument for investors to access financing while avoiding additional equity erosion, allowing them to keep a larger share of the ownership and profit. Other benefits for investors include;
- They can leverage the property with debt while maintaining equity and enhancing the return on equity.
- It’s possible that interest payments are tax-deductible.
- On the balance sheet, real estate mezzanine loans are reported as equity rather than debt, which may make it easier for borrowers to obtain further funding.
For Lenders
Despite the significant risk, mezzanine lenders can benefit from providing equity-backed finance to assist investors in closing a deal:
- For real estate mezzanine loans, lenders charge significant interest rates, frequently in the double digits.
- The possibility of gaining stock or control offsets the high risk.
- In some cases, mezzanine lenders may be able to place restrictions on the borrower’s ability to function.
Applications of Mezzanine Financing
Companies can use mezzanine finance to meet their capital needs in many cases where senior debt or equity would normally be used. It’s a long-term source of capital that helps companies achieve their growth objectives, whether it’s expanding manufacturing capacity or completing an acquisition that can’t be done with all senior finance.
Mezzanine finance provides additional leverage for a range of transactions, including the following:
- Recapitalizations
- Leveraged buyouts.
- Buyouts by management
- Acquisitions of growth capital
- Buyouts of stock by shareholders
- Refinancings
- Restructuring or optimization of the balance sheet
- Pricing and Payment Structure for Mezzanines
Furthermore, Mezzanine finance is more expensive than senior debt and less expensive than equity, but because it is a relative hybrid of the two, it is priced as a mix of the two. Mezzanine debt is typically subordinated debt or debt that matures a year after senior debt.
It’s usually set up with a mix of contractual interest – cash and payment-in-kind (PIK) – and nominal equity (warrants). It often has a bullet maturity and no amortization over the loan’s life.
Also, companies use senior debt capacity built up over time to refinance mezzanine loans before maturity, lowering their debt capital costs in the process. However, the mezzanine loan’s longer duration and lack of necessary amortization give crucial capital structure “patience” for the business to process the financing event (such as integrating an acquisition).
Picking a Mezzanine Financing Company
When deciding whether or not to take on mezzanine finance, there are several factors to consider. Below are some significant factors to look for when choosing a lender or investment:
- It’s essential for a mezzanine finance provider to be able to expand as a financial partner and to have the knowledge and experience to assist a firm through difficult times because it promotes long-term growth.
- The mezzanine provider is interested in supporting the long-term plans of the companies they fund.
- They should be more concerned with building relationships than with completing transactions.
- It’s essential that the mezzanine financing source be interested in supporting the long-term plans of the firms they fund, as well as working to understand their needs and how they operate.
- They should be quick to respond, and they have access to important decision-makers within their company.
- The mezzanine finance company should have a track record of providing mezzanine funding throughout market cycles and calendar years.
- They should stick to their word and deliver on their promises.
- The supplier should have extensive experience investing in a range of industries and can draw on this knowledge when addressing your company’s requirements.
Maturity, Redemption, and Transferability
Mezzanine financing usually has a five-year or longer term. The maturity date of any specific debt or equity issue, on the other hand, is often determined by the scheduled maturities of existing loans in the issuer’s financing structure.
But then, preferred equity does not usually have a set maturity date and can be called by the issuer at any time after it is issued. Redemption is typically used to take advantage of decreasing market rates by calling in debt and equity and re-issuing it at a lower rate.
In most cases, the lender in mezzanine finance has unfettered transfer rights. If the loan includes future payouts or advances, the borrower might be able to negotiate a qualified transferee requirement as a transfer restriction. Preferred equity, on the other hand, is frequently subject to restrictions or requirements on the purchaser’s interest in the corporation being transferred. The entity may allow transfers after all preferred equity has been provided.
Mezzanine Financing’s Benefits and Drawbacks
Like any other sophisticated financial product or service, mezzanine financing has benefits and drawbacks for both lenders and borrowers to consider.
Advantages
Lenders—or investors—may receive immediate equity in a corporation or acquire warrants to purchase stock at a later date as a result of mezzanine financing. This might boost an investor’s rate of return dramatically (ROR). In addition, contractually mandated interest payments are made monthly, quarterly, or annually to mezzanine finance providers.
Borrowers choose mezzanine debt because the interest they pay is a tax-deductible business expense, lowering the debt’s overall cost. Also, debtors can shift their interest to the balance of the loan, making mezzanine finance more manageable than other debt structures. Meanwhile, if a borrower is unable to make a scheduled interest payment, the interest may be delayed in part or entirely. Other kinds of debt usually do not have this choice.
Furthermore, when a company grows in value, it may be possible to restructure mezzanine financing loans into a single senior loan with a reduced interest rate, saving money in the long run.
As an investor, on the other hand, the lender is usually rewarded with additional equity interest or the option to obtain such interest as a bonus (a warrant). If the business is a big success, the tiny extras can become really valuable. Mezzanine debt also has a substantially greater rate of return, which is important in this low-interest-rate climate.
In contrast to the prospective but not guaranteed dividends supplied by preferred equity, mezzanine debt guarantees assured periodic payments.
Disadvantages
Due to the loss of equity, owners may give up some control and upside potential while obtaining mezzanine finance. Lenders may have a long-term outlook and require a board presence. The longer the mezzanine financing is in place, the more interest the owners pay. Restrictive covenants, which limit the borrower’s ability to borrow further cash or refinance older debt, are frequently included in loan agreements, as are financial ratios that the borrower must meet. Payout restrictions for important employees and even owners are not unusual.
In the event that the borrowing company goes bankrupt, mezzanine lenders risk losing their money. To put it another way, when a firm goes out of business, the senior debt holders get paid first from the company’s assets. Mezzanine lenders lose out if there are no assets left once the old debt is paid off.
Finally, negotiating and putting in place mezzanine loan debt and equity can be time-consuming and difficult. The majority of such transactions will take three to six months to complete.
Mezzanine Financing Example
Let’s assume Bank XYZ lends $15 million in mezzanine loan financing to Company ABC, a surgical device manufacturer. The money was used to replace a higher-interest $10 million credit line with better terms. Company ABC was able to increase its operating capital and pay off higher-interest debt, allowing it to bring more items to market. Bank XYZ will receive 10% interest payments per year and will be allowed to convert the debt into an ownership holding if the company defaults. Bank XYZ was also able to prevent Company ABC from borrowing more money and impose specific financial ratio requirements on it.
Mezzanine Loan FAQs
How does a mezzanine loan work?
Mezzanine financing is a mix of equity and debt financing that grants the lender the ability to convert the debt into an equity interest in the company in the event of default, typically after venture capital firms and other senior lenders have been paid. It lies between senior debt and equity in terms of risk.
What is a mezzanine real estate loan?
A form of finance that investors take on to support purchases or development projects is a real estate mezzanine loan. Within the capital stack, mezzanine loans are below senior debt but are given precedence over both preferred and common equity.
How are mezzanine loans repaid?
The mezzanine debt loan can now be refinanced by a bank using conventional collateral. If the company’s worth has increased sufficiently and the timing is perfect, the owner may sell the business and use the sale proceeds to pay back the mezzanine lender.
