Mezzanine Debt Definition
Mezzanine debt is a hybrid lending vehicle, commonly used by real estate developers to secure supplementary financing. It is also a position in the capital stack that individual accredited investors may be able to tap into via platforms like EquityMultiple.
Where Mezzanine Debt Sits in the Capital Stack
Mezzanine debt is a form of “gap” or “bridge” financing for real estate transactions. As part of a more complex capital stack, a sponsor may utilize senior debt, mezzanine debt, preferred equity, and common/JV equity. For individual investors accessing mezzanine debt investments via a platform like EquityMultiple, this position can offer a unique and potentially compelling risk-adjusted return profile.
In a “mezz debt” structure, the lender the right to convert to an ownership or equity interest in the investment opportunity if the loan is not paid back in time and in full. It differs from preferred equity in the sense that mezzanine debt requires a pledge of equity.
Depending on the commercial real estate (CRE) project, mezzanine debt can offer flexibility and enhanced overall return potential to the borrower, while offering an attractive rate of return to mezzanine debt investors over a relatively short investment term.
For a passive real estate investor, participating in mezzanine debt positions generally offers higher average target returns than senior debt, and mezzanine investors typically earn a 10% to 20% return on their investment.
Continue reading to learn how participating in mezzanine debt can potentially offer an attractive and unique return profile.
What Is Mezzanine Debt in Real Estate?
Mezzanine debt is a hybrid lending vehicle, commonly used by real estate developers to secure supplementary financing. For this reason, it’s also referred to as mezzanine financing. It is a flexible financing tool that can help all types of borrowers finance real estate investments.
It is generally “subordinated” to debt provided by senior lenders such as traditional banks. Subordinated, in this case, means lenders/investors in the mezzanine debt position have payment priority below senior debt (though above all equity positions). Mezzanine debt gets its name from the mid-level placement it has in the capital stack, much like how a mezzanine terrace is sandwiched between two floors. Notably, mezzanine debt offers a higher basis than a senior loan, but a lower basis than equity.
Either mezzanine debt or preferred equity may be used as bridge financing options for real estate. In the case that both are part of a project’s total capitalization, mezzanine debt will be senior to preferred equity. Senior debt, mezzanine debt, and preferred equity all entail payment priority over equity investors, as well as (generally) contractually obligated income and relatively short terms. These three income-oriented positions in the capital stack are represented in EquityMultiple’s ‘Earn’ pillar.
Update for 2024
In May 2023, mid-sized and regional banks began deleveraging and tightening lending standards following the collapse of multiple banks – namely Silicon Valley Bank, Signature Bank, and First Republic Bank. The emerging credit crunch will create more demand for bridge financing and debt capital from non-bank lenders. EquityMultiple is one such source of non-bank financing, such as mezzanine debt. As such, opportunities may emerge for attractive risk-adjusted returns in mezzanine debt for EquityMultiple and individual investors on our platform.
With rates elevated for the foreseeable future, we can expect that mezzanine debt investing could benefit and offer improved risk-adjusted returns.
A Brief History
“Middle-market” commercial real estate sponsors began looking more toward gap financing options like mezzanine debt and preferred equity following the GFC and subsequent regulatory policies enacted.
This financing tool bridges the senior debt and equity, typically accounting for 5%-20% of the total capitalization of a real estate investment. Although mezzanine debt is typically subordinate to a senior loan, it is senior to all equity. The rate offered to mezzanine debt investors will vary depending on loan-to-value (LTV) This is due to the associated risk levels equity investors carry compared to senior debt investments.
Types of Mezzanine Debt
Various types of mezzanine debt structures are used in leveraged buyouts. A capital stack involving mezzanine debt for private equity may include the following embedded options:
- Call options award investors the option to purchase a stock or bond as an underlying asset within a financial contract.
- Rights refer to stock instruments that can be provided to shareholders as a way for them to cement their slice of company ownership.
- Warrants are a way for long-term shareholders to buy even more shares of a stock at a lower price point.
The classification of a hybrid security like mezzanine debt is largely dependent on how the security is affected by its portion of the overall debt in a capital stack.
In some investments, mezzanine debt can be paid down pari passu with senior debt after the senior debt is paid down to a specific threshold.
How Mezzanine Financing Works
How does mezzanine work? Simply put, mezzanine debt financing has the potential for strong risk-adjusted returns, particularly late in the cycle when common equity investments may carry a higher degree of risk (despite their uncapped upside potential). In down cycles (like we may expect to see in 2023) mezzanine debt may also offer attractive returns, as traditional lenders may tighten balance sheets, leaving quality real estate developers or sponsors more in need of bridge financing.
Note: property values tend to decline in down markets, but with mezzanine debt, investors are still likely to be covered due to the investment’s low basis.
Mezzanine Debt for Sponsors
Mezzanine debt funds are one of several bridge financing options available to borrowers, along with junior debt, preferred equity, and other debt instruments. For real estate developers and sponsors, mezzanine debt financing typically works like this:
- Secure senior debt: Sponsors and developers determine a senior lender to provide as much capital, at as low of a rate, as possible. This senior lender may be a traditional bank or insurance company, often a party that the sponsor has worked with previously. In other cases, a broker may be utilized to find debt capital at the most favorable terms.
- Determine equity capital sources: based on senior debt afforded to the sponsor, they then assess the total capital stack based on their own equity in the deal and other equity sources. Based on the gap between senior debt and equity combined, versus 100% of capital needed for the project, a need may emerge for “gap financing” such as mezzanine debt.
- Source mezzanine debt lenders: Mezzanine debt lenders can potentially take the form of private equity funds, family offices, real estate crowdfunding platforms, or debt funds. Borrowers can find these lenders through debt brokers or existing relationships. At EquityMultiple, for instance, we often look to partner with creditworthy sponsors on a repeat basis to streamline operations for the sponsor and for our investors.
Mezzanine Debt for Investors
Mezzanine debt most often entails a pledge of the sponsor and/or developer’s equity stake in the real estate investment. So, in the downside scenario of a default by the borrower, the mezzanine debt investors can foreclose on the borrower’s equity interest and assume the day-to-day management of the project. This is a last resort, however, investors should consider taking the following steps to potentially help avoid risky mezzanine debt investments:
- Evaluate the credit-worthiness of the borrower: If you are investing in mezzanine debt via a platform like EquityMultiple, you are effectively acting as a bridge lender. Make sure that the platform has done diligence on the sponsor or developer (the borrower) and that you are comfortable with their track record.
- Evaluate the fundamentals of the investment: Source mezzanine debt lenders: Get comfortable with the neighborhood (or “submarket”) and the business plan.
- Scrutinize the entire capital stack: Make sure that the bridge financing is a sound element in an overall sound capital stack. If the borrower has little or none of their own equity in the project, or if bridge financing is being overused relative to the senior loan, this may be a red flag.
Pros and Cons of Mezzanine Debt
The success of financing instruments like mezzanine debt are dependent on the underlying real estate investment and its key components: the property, the market, and the borrower (sponsor).
The return potential of mezzanine debt may also depend on conditions in capital markets. The underwriting and leverage standards of traditional lenders may impact the market for mezzanine capital, and ultimately impact the return potential of mezzanine debt investments. As of 2024, we can expect that elevated rates and tight credit will allow mezzanine debt lenders (investors) to command relatively high interest rates (and therefore rates of return) for mezzanine loans to relatively creditworthy borrowers (sponsors).
Why would a sponsor take on mezzanine debt? Let’s take a look at some of the pros and cons:
Pros of Mezzanine Debt | Cons of Mezzanine Debt |
---|---|
Cheaper alternative to raising equity | Subordinated senior debt |
Accretive to IRR | Higher interest rates |
Flexible structuring options | Can be difficult to arrange |
Company equity is less liable | May restrict further credit usage |
Pros of Mezzanine Debt
For Sponsors
In a strong market, sponsors will generally be able to secure mezzanine debt at a lower rate. Borrowers can also take advantage of the following benefits:
- Flexible structuring options: Since mezzanine debt is subordinate to other debt structures, its percentage in the capital stack can be tailored to each asset
- Company equity is less liable: Using mezzanine debt is potentially a risk averse strategy for company equity since private equity funds will now be capable of investing in the asset
- Cheaper alternative to raising equity: Due to mezzanine debt’s long-term borrower-lender relationship, it offers individual investors a cheaper alternative to raising equity
For Investors
Mezzanine debt financing is potentially beneficial for accredited investors who invest in a loan to a creditworthy sponsor with a sound business plan. Primary benefits of investing in mezzanine debt include:
- A generally higher rate of return than participating in senior debt or other non-real estate fixed-rate investments
- Generally short hold periods
- Recourse in the case of default
- Payment priority to all equity position
Cons of Mezzanine Debt
For Sponsors
For sponsors and developers, the following considerations should also be taken into account:
- Subordinated senior debt: Mezzanine debt typically cannot be the primary financing option within the capital structure
- Higher interest rates: Depending on the amount of mezzanine debt used, a high interest rate can follow this financing option
- Can be difficult to arrange: Since mezzanine debt is subordinate to other debts within a capital stack, it can sometimes be difficult to arrange
- May restrict further credit usage: Depending on how much mezzanine debt is used, further credit usage may be restricted in the financing process
For Investors
For accredited investors, potential downsides of investing in mezzanine debt include:
- Capped upside
- More risky than participating in a senior loan
- Can be difficult to access as an individual investor
Note: the creditworthiness of the borrower, the quality of the underlying asset, and the strength of the market are also risk factors that investors should consider. While mezzanine debt offers payment priority, the risk factors are similar to any other debt or preferred equity investment. Investors should always consider the experience of the borrower (the real estate firm executing on the investment).
Real Estate Investor Tip
Mezzanine debt investors should pay close attention to the overall leverage of the project across senior debt, mezzanine debt, and any other bridge financing. The total loan-to-value (LTV) and debt service coverage ratio should remain appropriately conservative relative to the offered rate of return (the interest rate).
Sponsors, borrowers and general partners (GP) are liable for the capital stack structure so all financing options should be reviewed by involved parties and real estate asset managers if applicable.
What Kinds of Returns Can I Get on Mezzanine Debt Investments?
Recall that, as with any investment, return and risk bear an inverse relationship. As with any commercial real estate investment, the position in the capital stack will influence the range of target returns you can expect as an investor. Higher positions in the capital stack (equity) will have less downside protection and less payment priority, hence equity investors are compensated with higher potential return. Lower positions (debt) will generally carry more investor protections and payment priority. Hence, total return potential is lower (though distributions may be contractually fixed and more regular).
Mezzanine debt sits somewhere in between. Generally the total return for a mezzanine debt investment will be a rate higher than the senior debt position, but lower than the preferred equity position. Beyond these general parameters, typical rate (return) on a mezzanine debt investment will depend on the following factors:
- Capital markets: the higher the benchmark interest rate, the higher the general range of rates mezzanine lenders can capture.
- Borrower quality: the more credit-worthy the borrower (sponsor) and the more sound the overall financing, the lower the rate a mezzanine lender can capture (though a higher-quality borrower generally means a less risky mezzanine debt investment).
- Project risk: the more opportunistic the business plan, the higher the rate a mezzanine lender can command to compensate for risk.
- Fees: if you are investing passively through a platform like EquityMultiple, consider the fees that the platform or the lender will take, and consider the net rate of the investment. EquityMultiple typically takes a 1% annual asset management fee on mezzanine debt investments.
While these factors can shift over time depending on the market, mezzanine debt investors, investors can usually expect an annual rate between 10% and 20%.
Mezzanine Debt Example
Now that you understand what mezzanine debt is and why it’s important for investing in real estate, here is how mezzanine financing works in the real world.
Without a mezzanine loan, the senior lender contributes $900,000 of debt financing at a cost of 8% per year, while you contribute $600,000 in equity.
Assume profits are then taxed at around 35%. This capital stack structure could potentially be improved with the help of financial instruments like mezzanine debt.
Instruments like mezzanine debt are used in capital stacks as a viable way for investors and borrowers to diversify their financing options. Here is what financing a project could look like without the addition of mezzanine debt:
Financing a Project Without Mezzanine Debt | |
---|---|
Operating Income | |
Interest Expense | |
Pretax Income | |
After-Tax Income | |
Annual Return on Your $600,000 Investment |
With mezzanine debt, on the other hand, the senior lender contributes $900,000 of debt financing at a cost of around 8% per year.
The mezzanine lender contributes $300,000 of debt financing at 15% per year and investors are expected to contribute only $200,000 in equity. Mezzanine funders who take advantage of this hybrid lending vehicle could have a capital stack scenario similar to this:
Financing a Project With Mezzanine Debt | |
---|---|
Operating Income | |
Interest Expense | |
Pretax Income | |
After-Tax Income | |
Annual Return on Your $200,000 Investment |
The Bottom Line
Real estate mezzanine debt offers borrowers an alternative financing option that can potentially increase overall returns.
Accredited investors interested in commercial real estate can take advantage of mezzanine debt in order to help finance large investments like multifamily real estate.
Mezzanine debt positions may offer an attractive way to diversify from higher risk equity positions while maintaining healthy potential rates of return. At a time when inflation may eat into real returns of fixed-rate investments, mezzanine debt can also provide an attractive alternative to treasury bonds and other fixed-rate instruments.
Learn more about other equity financing options to start building your capital stack investment strategy today.
Real Estate Investor Tip
When investing in mezzanine debt, consider the experience of the borrower (the real estate firm executing on the investment), the creditworthiness of the borrower, the quality of the underlying asset, and the strength of the market.
FAQs About Mezzanine Debt
Have more questions about mezzanine debt? We have answers.
Who provides mezzanine financing?
Generally, lenders are responsible for providing mezzanine financing within the capital stack structure.
What is the difference between mezzanine debt and senior debt?
Oftentimes, mezzanine debt is viewed as more of an investment than a loan, while senior debt is a definitive loan provided by banks.
Is mezzanine debt comparable to other types of real estate investments?
Mezzanine debt sits between senior debt and preferred equity in the capital stack. All three positions may be worth considering if you prioritize contractual cash flow and relatively short terms.
What is a mezzanine type loan?
A mezzanine type loan is a financing instrument that investors can utilize when attempting to acquire, renovate or develop a real estate investment.
Why do borrowers like mezzanine debt?
Borrowers like mezzanine debt because they can benefit from equity appreciation greater than what the contract alone can offer.
Why do investors like mezzanine debt?
Investors like mezzanine debt because this hybrid financing structure has the potential to increase overall returns with less associated risk.
How long does it take to raise mezzanine debt?
Raising mezzanine debt can typically take around six months to one year if using a broker relationship.
What is the pricing for mezzanine debt?
Mezzanine debt pricing yield enhancement is typically around 13% to 15% in total.
What are the best ways to use mezzanine debt?
Some of the best ways to use mezzanine debt are as bridge financing instruments, multi-partner acquisitions and a leveraged buyout.
What are the parameters to be eligible for mezzanine debt?
On average, companies or investor LLCs with an EBITDA (earnings before interest, taxes, depreciation, and amortization) over $1 million may be able to secure mezzanine financing.