Mezzanine Financing Plays Important Role

By John Tax

It is expected that mezzanine financing, which fills the gap between senior financing and equity, will play a major role in the next few years as short-term mortgages come due in what continues to be a weak market. As senior lenders continue to be more conservative in renewing mortgages, borrowers will need to find cash from other sources. This will serve to create good opportunities for mezzanine lenders.

Mezzanine Loans: Explained

The term “mezzanine loan” refers to a special type of junior real estate financing that takes the form of debt unsecured by a second mortgage (the word literally means a story in a building between the ground floor and the upper floor). A mezzanine loan cannot be secured by a second mortgage because this would be unacceptable to the senior lender. The senior lender would be unwilling to assume the additional risk that a junior mortgagee would raise legal obstacles to the senior lender’s remedies in the event of a default by the borrower. Thus, the mezzanine lender must utilize forms of security other than a mortgage. The most common security is a pledge by the property owners of their equity. For example, if the property is owned by a limited partnership, the limited partners would pledge their interests as security for the mezzanine loan. As a result, a default of the mezzanine loan would not involve the real estate itself.

Higher Return

Because of the lesser degree of security for the loan, the mezzanine lender usually will insist on a higher return than for a traditional second mortgage. The exact return will depend on the risk level of the particular investment. For example, consider an income property subject to a first mortgage with a 70 percent loan value (LTV) ratio. A mezzanine loan that raises the LTV to 55 percent for a term of up to seven years might produce an 18 percent internal rate of return (IRR). The purposes of entering into such a loan might be to secure additional funds for renovating or modernizing the property or to provide gap financing until before the current first mortgage matures and can be refinanced. At the opposite extreme, a mezzanine loan enables a developer to show the 30 percent cushion often required by a construction lender.

In addition to the higher return, the mezzanine lender will want some recourse other than a foreclosure in the event of default. The most common remedy is the right of the mezzanine lender to take control of the borrowing entity. In addition, the mezzanine lender often insists on a guarantee by the equity holders.

Inter-Creditor Agreement

Once the mezzanine lender has reached an agreement with the borrower, the next step often is to negotiate an agreement with the senior lender. Such an agreement may be required by the terms of the senior loan even though the mezzanine lender has no lien on the property. The senior lender may welcome the role of the mezzanine lender, who would have the incentive to cure defaults by the borrower in order to prevent a foreclosure that would result in a loss to the mezzanine lender.

The mezzanine lender, however, often will want an inter-creditor agreement in any case in order to obtain certain promises from the senior lender, most notably the right to have notice of any defaults by the borrower, plus the right to cure defaults in order to prevent a foreclosure. In addition, the mezzanine lender may want the right, in the event the senior lender begins a foreclosure proceeding, to purchase the senior loan at a price equal to all amounts then due under the loan. Another request by the mezzanine lender might be that any increase of modification of the senior loan must be subject to the mezzanine lender’s consent.