Mezzanine financing is a type of debt capital, which the lender can convert into ownership of the borrowing company if the loan is not repaid in full and on time. It is essentially a hybrid between equity and debt financing that is most often used to finance a company’s expansion. Mezzanine property finance is typically subordinate to other debts such as those provided by venture capitalists and banks.
Mezzanine financing usually charges an interest rate in the range of 20 to 30 percent. This high interest rate is due to the fact that mezzanine financing requires little collateral and is typically provided quickly without allowing the lender to perform due diligence on the borrower. The primary advantage of mezzanine financing is that the borrowing company can treat it like equity, allowing the company to obtain conventional financing more easily. The borrowing company typically must have a proven track record within its industry and a solid expansion plan.
Senior lenders are becoming more restrictive with the loan-to-value of their loans, especially in real estate financing. This may force borrowers to spend more capital on a development project than originally planned. Borrowers normally wish to maintain a high level of liquid assets in order to maximize their returns. This method of structuring financial backing provides maximum leverage, but can also generate negative profits and reduce the potential profits of the deal. Mezzanine financing is a method of reducing the amount of capital that a private equity firm must provide for real estate financing.
Straight debt is the most common structure for mezzanine financing in real estate. The mezzanine lender has a subordinate position in the finance structure, where the loan has a combined loan-to-value as high as 85 percent. This lender has no equity in the cash flow of the project, nor does it have any control over the project’s management. The yield for this type of mezzanine funding is typically between nine and 13 percent, depending on the borrower’s strength and specific type of project. The terms of a mezzanine loan are typically similar to those of the senior loan.
A participating debt is a type of mezzanine loan that is a cross between a debt and equity. This structure allows the borrower to obtain a CLTV as high as 90 percent. The lender typically receives a lower coupon rate, although it can increase its total internal rate of return by charging an exit fee upon the sale of the project. The higher CLTV of a participation note means the lender should receive a yield in the 15 to 18 percent range, assuming a low-risk borrower.