Understanding Mezzanine Financing Real Estate Loans

Understanding Mezzanine Financing Real Estate Loans

We get it— the world of real estate financing and investing is filled with what seems like hundreds of confusing terms for different loan types. It can be frustrating trying to keep them all straight, particularly when an ‘expert’ starts throwing these terms around as if you should already be expected to understand each of them in depth.

But even within this world of confusing terms and loan types, mezzanine financing real estate loans are some of the least understood. Their unique structures, terms, and use cases make them one of the most misunderstood loan types in the real estate market. That’s a shame, because when used correctly they can actually be hugely beneficial to both the borrower and mezzanine lender alike.

At Clopton Capital, we’re anti-confusion. That’s why we decided to put together this post that would take the complicated elements of mezzanine financing for commercial real estate and make them as clear as possible for a layperson. We’ll take you through the basics of mezzanine financing real estate loans, how they’re structured, and when they’re best used. We’ll also help you know how to choose between mezzanine finance providers, understand the basic guidelines for lending, and look at the advantages of mezzanine financing for both investors and borrowers so that you can understand both sides of the equation.

The basics of mezzanine financing real estate loans

In construction, a mezzanine is a floor or story between two other floors or stories. It’s not entirely the first floor or the second floor— it serves as a way of connecting the two. This is how mezzanine financing got its name. Mezzanine financing for commercial real estate isn’t entirely debt financing or equity financing, it blends the two in the sense that it allows the lender to lend money in a debt financing structure but convert to an equity interest if the loan defaults.

Within the structuring of mezzanine debt, you’ll find what are known as warrants. These sounds frightening, but they’re essentially equity terms that are attached to the debt that allow any subordinated debt to boost in value and also allow flexibility when it comes to dealing with anyone who holds bonds on the debt.

Technically, mezzanine financing is one of the higher-risk types of debt as it connects debt financing and equity financing together. It falls beneath equity debt but above pure debt, meaning that it can result in one of the highest return rates available in real estate financing—often with rates starting at 10%+.

Generally, mezzanine financing for commercial real estate is sought in order to support a specific project. It also can benefit the likelihood of future creditors getting on board; because mezzanine financiers are seen as long-term investors, they’re looked on more favorably by other lenders who may enter the picture in the future.

How mezzanine financing loans are structured

While mezzanine financing can be incredibly effective in the right circumstances, many borrowers don’t fully understand exactly how these loans are structured—particularly when it comes to real estate. Generally, most mezzanine financing real estate loans have some specific traits in common when it comes to the way they’re structured.

The preferred equity they offer is junior to subordinate debt, which means that its often seen as equity resulting from senior members in the financing hierarchy.

Generally, mezzanine financing loans also offer a fixed part of the return. This makes them less diluted than general or common equity. Mezzanine financing also offers no principal amortization, and is more often unsecured and higher yield than senior debts.

And, of course, mezzanine debts are subordinate to senior debt and senior to common equity debts.

These aren’t the only differences between mezzanine financing and other, more common debt structures. But where they differ most is in the specific cases wherein mezzanine financing is most effective and desirable.

Why use mezzanine financing?

Generally, mezzanine financing for commercial real estate is a great option for closing the gaps after an initial lender or lender has contributed a loan. This can result in a borrower needing to add less of their own funds to the pot to afford the real estate purchase, and while the financing rates are higher, the mezzanine financing results in less money out of your pocket. This can result in an initial decrease in annual profits but an increase in return on equity.

Mezzanine financing can also be a powerful option for recapitalizations, leveraged buyouts, management buyouts, growth capital, acquisitions, and shareholder buyouts outside of the world of real estate investing.

Choosing between mezzanine finance providers

With so many lenders offering mezzanine financing real estate loans, how do you know which organizations are the best, safest bet for your investment? In general, there are a few key factors that let you know where to place your trust.

First of all, because mezzanine financing can be so complex (and potentially high-risk), you want to partner with an established lender that offers a long history of mezzanine-specific loans.

You’ll also want to find a lender who offers reasonable loan terms, straightforward loan application and underwriting processes, and complete transparency throughout the process.

Finally, it’s important that the lender you choose be accessible. Mezzanine financing for commercial real estate is complex, so the ability to speak to a human being whenever necessary to understand more about the structure of your loan is absolutely vital.

And remember—if you want to know more about how a certain lender operates within mezzanine financing terms and other real estate loan structures, your best bet is to speak with them directly.

Standard mezzanine financing guidelines

While we can’t speak to the general terms offered by other lenders, we believe Clopton Capital’s standard mezzanine financing guidelines are a great starting point for understanding the standard terms and conditions to expect on your mezzanine financing real estate loan.

  • Loan sizes ranging from $1 million to up to $25 million, with no limit on total capitalization.
  • Nationwide availability, meaning that there’s no limitation on which areas of the country or cities you’re allowed to receive funding for when seeking to purchase a property with mezzanine funding
  • Commercial properties only—residential properties are not eligible for mezzanine financing real estate loans
  • Transactions typical of mezzanine financing include recapitalization, value-add, construction, and acquisition
  • Terms are based on cost of capital scenarios, and are always competitive with the current market

Have more questions about standard mezzanine financing guidelines? Feel free to contact a commercial mortgage broker at Clopton Capital to learn more and discover how mezzanine financing real estate loan terms will be structured for your unique scenario.

A mezzanine financing case study

In order to illustrate how mezzanine debt works, when it can be effective, and the terms it can offer, here’s a real-world case study from Clopton Capital’s history to help explain the process.

A company was seeking mezzanine debt to purchase an apartment development in Virginia. The investors hoped to use part of the company’s equity in another complex already owned as collateral for the down payment in order to bypass the process of refinancing the initial liens on the other, existing properties. Even though the loan to value ratio was excellent, local banks just didn’t have the flexibility to deal with this kind of scenario. Clopton helped the borrower structure a $3 million mezzanine loan, secured against the LLC’s existing portfolio and the new building. The client never even had to refinance their loan, which meant that other lenders on the property didn’t experience any level of disturbance.

Mezzanine financing real estate loans aren’t ideal for every scenario. They require high interest rates, and are generally a higher-risk loan than some other styles. But the potential for major benefits and savings is high, and smart borrowers who work with experienced lenders can arrive at terms that are hugely beneficial for them and their future plans.

Want to learn more about mezzanine financing? Reach out to Clopton Capital today.