Mezzanine debt is typically used to bridge the gap between real estate investors’ equity and the senior debt from their lenders. In this type of capital arrangement, assets are usually not secured, and the lender has to rely purely on the company’s ability to repay debt from its free cash flow. As a result, investors can earn a higher rate of return, given the high level of risk involved with mezzanine debt. Depending on the risks associated with the project and the amount of equity invested by the sponsors, the returns could range from 12% to 20% per year.
Mezzanine debt can be used for various purposes, including financing for corporate expansions, acquisitions, leveraged buyouts (LBO) and management buyouts (MBO).
Read also: What is loan-to-value (LTV) ratio?
How does mezzanine debt work?
When it comes to real estate investments, mezzanine debt comes after senior debt. The debt is usually subordinated, but there may be elements of equity as well. Subordinate debt means that all earnings will go towards repaying mezzanine debt once senior debts and operating costs are settled. It follows the principle whereby senior debt lenders are paid first, followed by mezzanine lenders, preferred investors, and finally, the common shareholders. Payment defaults can lead to a mezzanine lender seizing the equity position and possibly even taking over the property and the mortgage.
It is imperative for parties to MBO and LBO transactions to understand where they stand in this repayment line-up since repayment risks increase as you move down the chain, resulting in mezzanine debt carrying a higher interest rate.
Mezzanine debt and its benefits to real estate investors
Conventional real estate transactions typically allow investors to finance up to 80% of the property’s value with a mortgage, while the remaining 20% is covered by equity. By taking on mezzanine debt, investors can reduce the amount of equity needed to fund acquisitions or expansion projects, and use the amount saved from the reduced equity required from one project on other projects, further leveraging their returns.
Suppose an investor wants to buy a $100 million commercial property. However, the senior lender may only lend up to 75% of the property’s value, or $75 million, leaving $25 million for the investor to cover by equity. Suppose the investor does not have $25 million in capital available or is unwilling to commit to a deal that requires such a sizable investment. He may then obtain a $10 million mezzanine loan.
Having secured $85 million in debt financing, the investor will only have to contribute $15 million in cash for the buyout. By doing so, the investor maximises his potential return and minimises the amount of capital for the purchase, allowing him to use the rest of the equity for another business opportunity. In addition, mezzanine loans are generally not repayable during the loan term but only at the end, which gives the borrower enhanced cash flow.
Difference between senior debt and mezzanine debt
Mezzanine debt and senior debt differ in several ways.
Mezzanine debt is a form of capital that combines a loan with an investment, while senior debt is a pure loan from a bank or lender. Unlike senior debt that is secured by assets, mezzanine debt is unsecured and determined solely by cash flow. Because of this, the qualification criteria for borrowers vary - senior lenders evaluate the borrower’s assets, whereas mezzanine lenders evaluate the borrower’s EBITDA, EBITDA margins, and the borrower’s historical cash flow.
In addition, mezzanine lenders consider growth opportunities and the management team’s capabilities. Once the mezzanine loan is issued to the borrower, the mezzanine lender is entirely reliant on the borrower’s future cash flow to repay his principal. Therefore, mezzanine lenders incur higher risks than a senior lender, resulting in higher lending rates. Also, mezzanine lenders have a higher upside because the company usually issues warrants to them. A warrant’s value is based on the company’s future value.
Generally, mezzanine debt and senior debt are used in harmony with one another. Mezzanine lenders place their capital below senior loans and have an inter-creditor agreement with banks. Through the application for mezzanine debt, the company’s growth and acquisition can be funded. This helps the company increase its assets, which further increases its ability to handle senior debt.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.