Buying commercial properties is often complex, requiring reams of paperwork and huge financial commitments. A simple down payment/mortgage situation may not be possible, in part due to the millions of dollars that are involved in huge commercial real estate transactions. To get the deal done, big borrowers often need the help of a mezzanine loan.
For those not in commercial real estate, a mezzanine may conjure up a picture of that “extra” level that is located between two main floors, often at a theater or concert hall. While these mezzanines are two different creatures, the building description can be applied to the loan type as well. These loans function somewhere between debt and equity, the two main financial floors, making them an important step in financing commercial real estate. Instead of a claim to part of the real estate project or other property, the lender takes company stock as collateral.
Who Uses Mezzanine Loans?
Not everyone can use this type of financing. In general lenders will only provide it when the company involved has an impressive history of quality and profitability. In addition, lenders want to see sound expansion plans from the company that demonstrate growth potential. In short, you need to be an established industry player to get one of these loans.
Mezzanine loans are generally for large amounts, usually around $10 million. In fact, most of these lenders will not make a loan for under $5 million. Preparing these loans is labor intensive, so lenders are reluctant to spend that much time on loans smaller than that. Larger businesses and corporations are almost always the customers for these loans.
Experts say that there are several types of lenders for mezzanine loans. Business people who are planning new construction often apply for them, primarily because commercial construction lenders often demand that the borrower come up with 40% of the construction cost, a hefty amount in most instances.
Also, a borrower may want to “pull out” equity from a property that has grown in value. The terms of the first mortgage may make getting cash from refinancing difficult. A mezzanine loan will allow the borrower to receive some desired capital.
How Do Mezzanine Loans Work?
A mezzanine loan usually carries an interest rate somewhere between 12% – 20%, while the average 2018 commercial real estate loan interest rate is around 4%- 5%. These higher rates carry some risk for the borrower and possible healthy returns for the lender. It functions a little like a second mortgage, but instead of using a property as collateral, a company uses stock in its company. Suppose a buyer is after a $100 million property. They get $75 million traditional financing and agree to put up $15 million of company money. They may be able to get the remaining $10 million through a mezzanine loan, which reduces their capital investment and allows them to move forward with the purchase.
Pros of Mezzanine Financing
One obvious advantage is that companies do not have to come up with as much cash during an acquisition when they use this form of financing. Mezzanine debt is also tax-deductible, which is extremely attractive to borrowers. They can also include the amount of interest they expect to pay as part of the loan balance.
These loans come with a great deal of flexibility as well. When borrowers cannot make an interest payment, their lender may defer some or all of that payment, something that does not often happen where other loans are concerned.
If the company “takes off” after the acquisition, it will grow in value, often quite quickly, allowing management to restructure their mezzanine loan into a traditional loan that comes with a lower rate of interest.
Cons of Mezzanine Financing
Mezzanine loans do come with some drawbacks. For instance, the lender can foreclose on them quite quickly. If the borrower does not make a payment, the lender can foreclose in a mere five weeks as opposed to approximately 18 months to foreclose on a mortgage. While this is a disadvantage for the borrower, it certainly makes life easier for the lender. In fact, the lender can end up owning all the stock of the borrower’s company and perhaps claim ownership of the investment property.
In the case of these loans, the borrower’s investment ranks after the primary investor and the mezzanine loan, meaning they can rather easily lose their entire investment if things do not go well.
Mezzanine loans allow big borrowers with an excellent financial history to reduce their initial capital investment and possibly increase their rate of return. Often, coming up with the required investor portion of a mortgage can impose too great a burden on a company, impeding its ability to function as it needs to during its day to day operations. If the property investment prospers, the borrower can often convert the mezzanine loan into a traditional loan, thus reducing the high rate of interest and saving the business a significant amount of money.
These loans are also somewhat risky and come with a high rate of interest and a quick foreclosure period. In some cases, the lender ends up owning the company.
For those borrowers with big projects, a mezzanine loan may be the best way to go, particularly if they fully understand the potential risk/benefit ratio.