Mezzanine Financing in Real Estate

NMI 5000-017: Directed Reading & Research

Mezzanine Financing in Real Estate

JD Park

1. Introduction

In the US real estate market, non-conventional traditions to finance commercial properties have developed and progressed over the last decade. One of the newly advanced financing approaches was mezzanine financing. Mezzanine financing includes B-note, mezzanine loan and preferred equity in the capital structure. Typically, mezzanine finance is widely used to fill the differences between first mortgage debt or A-note and owner's equity.

Before the global financial crisis in 2007, mezzanine financing had provided liquidity to the market with the high LTV up to 95% of the property value. Mezzanine financing lenders could enjoy higher interest rates and associated fees including origination, extension, and termination in return for the greater risks. After the crisis along with the downturn, real estate owners and developers had such a difficult time to source the funds because of tightening underwriting standards by the traditional lenders would not satisfy the condition that allows providing the liquidity on types of the capital stack. Consequently, real estate owners and developers needed to seek alternative funding capital, resulting in new players participating in the mezzanine lending landscape to provide liquidity into the market. These newly engaged lenders are mostly private equity funds and hedge funds who are looking for investment opportunities to take advantage of the illiquidity and funding gap in the market during the period. Throughout the mezzanine financing, real estate owners, and developers could secure necessary capital required for their projects. By contrast, mezzanine lenders could go into the market and pursue high yield investments along with high origination fees and participation interest.

1. What is the real estate Mezzanine debt?

Real estate developers and investors have always used a combination of debt and equity to finance their projects and acquisition. Mezzanine debt inflows a difference and gap in the financial structure of the first mortgage and equity. Mezzanine debt is subordinate to a first mortgage but takes priority position over the property owner’s common equity. Mezzanine debt achieves a higher return than a first mortgage but lower than the total return that accrues to an equity position.

For the borrowers’ perspective, a mezzanine loan is a means of limiting equity dilution, maintaining control over the assets and capturing all of its upside capital gains. While more expensive than senior debt, it is cheaper than equity. For existing stabilized properties, a mezzanine loan may also provide a way to unlock value that has been created over development or holding period.

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