Most people are familiar with the debt and equity portions of real estate finance. There is often another tier in the capital stack, however – “mezzanine” financing.
This is a lot like it sounds – the mezzanine level is like the semi-floor, halfway up the stairs, that in department stores like Fields and Macy’s was used for just about everything in between the women’s and men’s displays on the 1st and 2nd floors. In real estate finance and the “capital stack,” the 1st floor is debt, and the 2nd floor is straight equity. Mezzanine financing is every other imaginable type of financing in between.
Among other things, mezzanine financing can be:
- Any type of junior debt, whether holding the 2nd position, the 5th position, or completely unsecured;
- Preferred equity, where there are specified rights above common equity, but below senior debt;
- Convertible debt, which is debt that converts into common equity at specific terms; and
- Participating debt where interest payments are combined with participation in property income above a specified level.
The last two options may seem to be the best of all worlds — but of course getting a share of the income or of the capital appreciation comes at a price. Usually that price is in the form of lower interest rates, higher loan-to-value (LTV) ratios, or less favorable contractual terms.
The bulk of real estate financing is still either straight senior secured debt or common equity. Sometimes, however, sponsors (and investors) prefer a customized mezzanine financing.
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How Does It Work?
Typically, deals with mezzanine debt are structured with a 70 percent mortgage, a 5 to 25 percent mezzanine debt, and the remainder from the developer’s equity. Unlike a mortgage, a partnership interest is often assigned in case the developer defaults on the loan/equity. This makes mezzanine financing effectively a debt-equity instrument — one whose pricing typically reflects that hybrid position. Mezzanine financing is thus best compared with preferred equity investments.
Mezzanine instruments are typically short-term, and anticipate exits by either substitution with lower-rate debt or a property sale. They typically also demand a healthy premium over permanent, senior debt rates. Not only are the interest rates higher, but mezzanine capital is typically short-term in nature – so that investors can get a relatively quick exit. All this sounds great for investors, of course – but why would sponsoring real estate companies pay this premium?
The answer is that mezzanine products typically replace common equity, which in fact is the most expensive money that a developer/sponsor has to raise. Because common equity is in a “first loss” position, investors typically demand not only a “preferred return” – a dividend-like periodic payment – but also a portion of the upside, or “carry,” that the developer would otherwise have to himself. Sponsors who are confident of the potential upside often prefer to pay a higher interest rate on financing that is “capped,” which is to say that it doesn’t participate in the upside appreciation potential (and thus doesn’t exceed a fixed price).
At What Cost?
The benefits of mezzanine financing come with both greater risk and higher cost to sponsors. The risk is that the increased leverage puts the common equity position at increased risk of “erosion,” should property values decline. The cost is in the higher weighted average cost of debt capital, since most mezzanine structures are still, in essence, debt-like. And to investors, the risk is that they are now in a second position behind the senior first-position debt – and so have less true equity “cushion” to buffer them. These risks were highlighted in the aftermath of the Great Recession, when real estate value declines hit instruments like these hard – leading to frozen credit markets and a shriveled market for commercial mortgage-backed securities (CMBSs).
The demand for mezzanine financing never went away, however. If developers have a choice between equity financing of, say, 40% of the project cost with investors demanding a return of 20-25%, compared to a mezzanine piece that would bring that costs down to the 15-20% range for the majority of that needed capital, many confident developers will choose the mezzanine option.
Real estate’s relatively stable cash flows lend themselves to the prudent use of leverage to enhance a sponsor’s returns and to diversify their portfolio. Real estate is also, however, a long-term asset, and a significant equity cushion is needed to see everyone through the tough times that inevitably and unexpectedly occur. If that is in place, however, then mezzanine financing can be an attractive option for both sponsors and investors – which explains why the mezzanine market is currently enjoying a resurgence, now that the economy has largely pulled out of its funk.