As a real estate investor, it's important to understand the different levels of financing with each real estate project. The better you understand the financing, the more clearly you can assess the potential risks and returns of the project.
Mezzanine finance comes from a building metaphor. In earlier days, department stores like Macy’s would frequently place a café on the mezzanine, between the first and second floor, as a way to incentivize hungry patrons to climb the stairs.
Investors, too, may find the mezzanine to be an attractive destination. When it comes to real estate, the first floor of the “capital stack” for a given investment is senior (1st-lien) debt; the second floor is common equity. Mezzanine financing is everything in between.
Various Forms Of Mezzanine Finance
Any type of junior secured debt, whether it’s the 2nd-position lien, the 3rd-position lien, the 5th-position lien, or completely unsecured is a type of mezzanine debt.
Mezzanine debt: where the security is in the form of a pledge of the equity interest in the borrower.
Preferred equity: where there are specified rights above common equity, but below senior debt.
Convertible debt: which is debt that converts into common equity at specific terms
Participating debt: where interest payments are combined with participation in property income above a specified level.
The last two options may seem attractive, but of course getting a share of the income or capital appreciation comes at a price—usually in the form of lower interest rates, higher loan-to-value (LTV) ratios, or other less favorable contractual terms.
Much of real estate financing is still done through a combination of senior secured debt and common equity. But in many cases, sponsors and investors prefer to employ “gap” financing that lies “between” the two traditional options aka mezzanine financing.
How Does Mezzanine Financing Work?
Many transactions involving mezzanine debt are structured like this:
- A senior mortgage loan, often with a loan-to-value (LTV) ratio of 60-65%
- Mezzanine financing for 5-25% of the remaining project financing
- And the remainder from common equity from the developer and others
Mezzanine financing thus serves to fill the “gap” that remains when a lender doesn’t want to extend themselves beyond a certain point—and where the common equity raised is insufficient to fill up the balance of the financing needed. Gap financiers have learned to be comfortable with a position in the capital stack that is effectively subordinate to the senior mortgage loan, but superior to common equity.
Mezzanine instruments are typically short-term in their investment horizon so that investors can get a relatively quick exit. That usually comes through substitution with lower-rate debt or by a property sale. Mezzanine investors also typically also demand a healthy premium over permanent, senior debt rates.
Related: Real Estate Learning Center
Why Developers May Prefer Mezzanine Financing
All this sounds great for investors, of course—but why would sponsoring real estate companies pay this premium?
The answer is that mezzanine products typically replace common equity, which is the most expensive money that a developer/sponsor has to raise. Because common equity is in a “first loss” position, investors typically demand not only a “preferred return”—a dividend-like periodic payment—but also a portion of the upside, or “carry,” that the developer would otherwise be able to keep to himself.
Sponsors who are confident of realizing on that potential upside often prefer to pay a higher interest rate on this “capped” financing— money that doesn’t participate in the upside appreciation potential – and thus doesn’t exceed a fixed price.
Think about if you were a hot startup, growing by 100% a year for at least the next 5 years. You wouldn't want to raise capital in exchange for giving away equity. Instead, you would much prefer to raise capital via debt, even if the debt cost 20% a year. Theoretically, you would be willing to pay up to a 99% interest rate, but of course, you wouldn't.
The Risks of Mezzanine Financing
The benefits of mezzanine financing come with both greater risk and higher cost to developers.
For common equity holders (including the developer), the risk is that the increased leverage puts those investors at increased risk of capital loss if property values decline. For mezzanine investors, the risk is that they are in a second position behind the senior first-lien mortgage debt—so they have reduced equity “cushion” to buffer them.
Mezzanine financing serves to fill the gap that remains when a lender doesn’t want to extend themselves beyond a certain point—and where the common equity raised is insufficient to fill up the balance of the financing needed.
These risks were highlighted in the aftermath of the Great Recession, when plummeting real estate values hit these instruments hard—leading to frozen credit markets and a shriveled market for commercial mortgage-backed securities (CMBSs).
Still, demand for mezzanine financing never went away; in fact, it has grown in recent years. To understand why, let’s imagine an example.
A developer is thinking about financing 40% of their project costs with common equity. In that case, investors would demand a return of 20-25%.
Alternately, he could include a mezzanine piece that would bring costs down to 15-20%. Many confident developers would choose the mezzanine option, hands-down.
Related: Why Real Estate Is My Favorite Asset Class To Build Wealth
Default Remedies For Mezzanine Debt
In the event of a default, mezzanine loan investors do not pursue a property foreclosure, but rather a foreclosure on their equity (stock) in the company that holds the title to the property.
This remedy centers on the Uniform Commercial Code and offers a dependable—though somewhat involved and not-super-fast process. Once the mezzanine lender owns that stock and the associated control rights, it effectively owns the commercial project going forward.
Mezzanine instruments are typically short-term in their investment horizon so that investors can get a relatively quick exit. Mezzanine investors also typically also demand a healthy premium over permanent, senior debt rates.
Mezzanine debt, though, has a few disadvantages. Some property lenders continue to avoid making mortgage loans where mezzanine financing is also in place; at a minimum, they typically seek inter-creditor agreements that clarify the rights of the two lenders.
Also, the UCC foreclosure process is tried-and-true, but it is a little unwieldy; it involves, among other things, a “commercially reasonable sale process” that involves an auction-type marketing process. While this can be done inside of 60 days or so, it’s still a bit cumbersome and takes some time and money to orchestrate.
Finally, the mezzanine lender must still have a relationship with the first-lien lender that allows the mezzanine lender to exercise their rights even while the first-lien lender must forestall on exercising their own rights. This is why inter-creditor agreements can sometimes be difficult to negotiate.
Why Mezzanine Loans Can Be Attractive
Mezzanine loans can sometimes serve strategic purposes beyond their usual role of providing “gap” financing.
For instance, a lender might strategically divide their loan amount between senior and mezzanine tranches. That’s because, in some states, the property foreclosure process may need to run through a judicial review and can take several years—much slower than the same process for collateralized equity. So “splitting the baby” in these situations can actually be a wise move for a lender.
The benefits of mezzanine financing come with both greater risk and higher cost to developers.
Real estate’s relatively stable cash flows lend themselves to the prudent use of leverage to enhance a sponsor’s returns. Because real estate is a long-term asset, a significant equity cushion is needed to see everyone through the tough times that inevitably and unexpectedly occur.
If that equity cushion is in place, mezzanine financing can be an attractive option for both sponsors and investors – which explains why the mezzanine market is currently enjoying a resurgence.
Keep in mind that real estate investments involve risk and are not insured; as such, they run the risk of loss, including the loss of invested capital. Before investing, you should carefully review the offering materials and arrive at a realistic understanding of your own risk profile.
Related: What Is a Preferred Return In Regards To Real Estate Investing?
Invest In Real Estate With The Largest Platforms
With real estate crowdfunding, you don't need to risk $100,000 or more to invest in commercial real estate. Instead, you can invest for much lower amounts such as $5,000. If you're interested in looking at some mezzanine investments, the best real estate crowdfunding platforms today are:
The best real estate crowdfunding platforms today are:
1) CrowdStreet is based in Portland and connects accredited investors with a broad range of debt and equity commercial real estate investments. CrowdStreet is great because they focus primarily on 18-hour cities (secondary cities) with lower valuations, higher net rental yields, and potentially higher growth.
2) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. I’ve worked with Fundrise since the beginning, and they’ve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding space to take advantage of new tax laws.
Both of these platforms are the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals. Sign up and take a look around as it’s free.
As always, do your own due diligence and only investment in what you understand. I’ve personally got $810,000 invested across 18 different commercial real estate projects around the country. My current internal rate of return is about 15% since 2016. Below is my dashboard.
About the Author: Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years after attending The College of William & Mary and UC Berkeley for b-school working at Goldman Sachs and Credit Suisse. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has $810,000 invested in real estate crowdfunding.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $220,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.