Mezzanine financing in commercial real estate refers to a type of secondary, unsecured debt that is subordinate to the primary mortgage. It is used to fill the gap between senior debt and equity. In the event of a default, mezzanine debt can be converted into an equity interest in the property. This financing tool combines elements of debt and equity, providing investors with additional leverage while maintaining, or improving, their return on equity (ROE). It often carries high-interest rates and is considered riskier for lenders due to its unsecured nature.
The article explains the concept of mezzanine financing detailing its structure, benefits, and risks.
When structuring a capital stack in a commercial real estate transaction, investors often find they have less than the ideal amount of equity to invest. Typically, investors sell equity or seek additional debt financing in such situations, which reduces their return on equity (ROE).
But what if investors could incorporate more debt into the deal and maintain their ROE while minimizing the drawbacks of excessive debt?
This is where mezzanine financing comes in. Mezzanine financing derives its name from mezzanine floors in buildings, situated above the ground floor. Here’s an overview of mezzanine financing in commercial real estate, how to evaluate its suitability for your portfolio, and what to watch out for when choosing this financing option.
Mezzanine financing, or mezzanine loans, in commercial real estate are secondary financing instruments that are junior to first mortgages. Investors repay these loans using the cash flow from their properties. In the event of a default, investors negotiate with lenders to convert outstanding debt into an equity interest in the property.
Also known as subordinated or second-charge debt, these loans are either not secured against the property or are subordinated to the senior mortgages, making them riskier for lenders. Here’s an illustration of a capital stack in a £10 million deal using mezzanine debt.
Mezzanine financing in commercial real estate is used by investors to cover the cost of a deal when the amount of senior debt falls short. In case of a default, investors and lenders negotiate to convert outstanding debt into equity stakes in the deal.
Thus, mezzanine financing is a hybrid of debt and equity financing, providing investors with the cash they need to boost returns while minimizing the downside of traditional debt.
Mezzanine financing is not unique to real estate. Private equity investors also use mezzanine debt in leveraged buyouts to acquire a stake in a target company.