What is Mezzanine Debt for Real Estate Investing? What is Mezzanine Debt for Real Estate Investing? | Winterspring Capital

What is Mezzanine Debt for Real Estate Investing?

What is Mezzanine Debt for Real Estate Investing?

What is Mezzanine Debt for Real Estate Investing?

Mezzanine debt is an important layer in the multifamily capital stack.  If there’s a gap in financing and the senior loan and total equity raised are insufficient to purchase an asset, mezzanine debt may be used.  How exactly does mezzanine debt work?  In order to understand mezzanine debt, we have to quickly review the full capital stack so we can see its place in context.

It’s extremely important that you familiarize yourself with the capital stack if you have a goal of being involved with large multifamily acquisitions.  The way the capital stack works is each source of capital is given its own layer.  The total amount of capital invested in its entirety is the capital stack.  

The lower the position a source of capital occupies on the stack, the higher they are in the priority list for repayment.  For the increased risk involved with being lower in the order of repayment, the top layers of the capital stack have the potential for much higher returns.

You should remember that mezzanine loans are not always used when syndicating a multifamily purchase.  As a result, you may not have encountered a deal that includes mezzanine debt in its capital stack.  

That said, mezz loans are an important part of multifamily financing and you’re running blind if you have no idea what they are.  After reading this article, you’ll be a little better prepared if you so happen to stumble across a deal that includes some mezzanine debt within the capital stack. 

If you’re involved in a smaller deal like buying a duplex, the debt from the senior loan and your own cash as the equity will likely be the only layers of the stack.  Large multifamily deals in the tens of millions in price behave a little differently and may have more parties involved in order to obtain the amount of capital necessary to get the deal done. 

What is Mezzanine Debt for Real Estate Investing?

In a multifamily real estate transaction, a more complicated capital stack will likely include a combination of senior debt, mezzanine debt, preferred equity, and finally common equity.  Let’s take a quick look at each of these capital sources.

Senior Debt:

Senior debt, occupying the bottom of the capital stack, is the type of mortgage or loan you’re likely already familiar with.  This is the typical loan type that is used to finance multifamily purchases. 

Depending on the asset itself and market conditions, senior lenders can provide up to 80% of the property’s value. 

Take a look at our
10 Things You Need to Know about Multifamily Financing article if you want a more complete discussion on the topic.

Mezzanine Debt:

What about those deals where the senior lender is not willing to lend such a high percentage of the asset value? 

This is where mezzanine debt comes in.  It’s used to fill gaps left in these situations.  Read the complete below for an overview of mezzanine financing.

Common Equity:

When you’ve heard people refer to “equity” in real estate, it’s generally assumed to be common equity.  This is the “default” form of equity that every homeowner has. 

For a real estate syndication, both the general partners that put the deal together and their limited partner investor base are common equity holders. 

The limited partners will still receive their preferred return before the general partners receive any cash flow distributions, but they are technically all common equity holders. 

There is just a division of payout priority within the common equity classification, with investors receiving payouts first in our syndications. 

Head on over to our
What is a Real Estate Syndication for Multifamily Investing? and What is a Preferred Return in Real Estate Investing? Articles to go more in-depth on these subjects.

Preferred Equity:

This is a second form of equity that has higher priority than common equity within the capital stack.  Preferred equity is commonly structured with a joint venture agreement between the real estate syndicate and an outside investment group. 

The general and limited partners act as one entity in the form of the syndicate to enact this agreement. 

Like mezzanine debt, preferred equity is used to fill gaps in financing and is a hybrid product in between the risk-return profile of traditional debt and equity. 

Our
What is Preferred Equity for Real Estate Investing? article explains this topic in more detail.

Mezzanine Debt 101

In architecture, a mezzanine floor is an intermediate floor, typically the second floor, that opens up to the first floor below.  Like its namesake, mezzanine debt occupies the second layer of the capital stack, right above the first floor — senior debt. 

This puts it in a superior position to all forms of equity (common and preferred), but lower priority than the senior lender.

Mezzanine loans allow an investor to reduce the total amount of equity needed for a deal by adding a second debt note to the purchase. 

These loans are typically much shorter in duration, extending from 2-10 years depending on the project and lender, with the industry average being around 3 years.  

While mezzanine loans are usually not collateralized, the interest rate can be up to three times as high as the rate on the senior debt for the same property. 

That said, mezzanine loans are commonly interest-only, reducing the debt service payments in exchange for a static principal over the life of the loan.

Lender’s Delight

From the perspective of the mezzanine lender, mezzanine debt is an attractive option.  The higher interest rates provide a greater return to the lender than a traditional loan, while still maintaining lower risk than an equity investor due to its superior position in the capital stack.

What is Mezzanine Debt for Real Estate Investing?

Occupying the middle ground in the risk-reward continuum between debt and equity sources, mezzanine debt is a hybrid option that can earn the lender an additional return on their capital, while providing a vital funding source for multifamily investors and developers.

While the mezzanine lender might be thrilled to offer you their services, they must also get the senior lender’s blessing in order for the deal to move forward. 

Given their superior position in the capital stack and their role as the largest capital provider in the transaction, the senior lender will determine if and how mezzanine debt can be used. 

The two lenders hash out these terms through what is known as an inter-creditor agreement.  

Underwriting Standards and Mezzanine Debt

Strict underwriting practices are logically correlated to an increase in mezzanine debt in multifamily financing.  With the tightening up of underwriting standards

What is Mezzanine Debt for Real Estate Investing?

Following the great recession, mezzanine lenders have carved out a niche for themselves in those transactions where the senior debt and existing equity sources are insufficient to fully fund an acquisition.  

Conversely, as the loan to value ratio rises in the marketplace, mezzanine loans begin to dry up due to the availability of additional leverage via senior debt.  Put simply, when senior lenders leave gaps in funding, mezzanine lenders step up to fill in those gaps.  Their importance in the marketplace will vary depending on where you are in the economic cycle.

What About Preferred Equity?

For those of you who have read our What is Preferred Equity for Real Estate Investing? article, you might be wondering what the difference is between mezzanine debt and preferred equity.  The difference lies in the names – despite the similar purpose and a comparable cost for both products, one is a form of debt and the other is a form of equity.  

Mezzanine loans are provided by certified lenders that must adhere to the Uniform Commercial Code, prohibiting them from including language in the loan documents that would allow them to take control of the property in an adverse event without first going through the courts.  Preferred equity investors are not so restricted and can engage in aggressive or even predatory behavior.  That’s why it’s extremely important to work with a preferred equity provider that has a good reputation.

The cost of capital for mezzanine debt and preferred equity is comparable as well, ranging from as low as 10% to as high as 20%, given the market conditions and the acquisition type.  Development projects and existing assets in need of serious work to reach stabilization will typically come with a higher cost of capital for both mezzanine debt and preferred equity. 

Another major difference between the two is how they are viewed come tax season.  Mezzanine debt has a significant advantage in this arena because of the ability to deduct the interest payments from your taxable income for the properly.  This reduces the tax liability for investors when comparing mezzanine debt to preferred equity apples-to-apples.

Lending Criteria

Due to the difference in how the loans are collateralized, mezzanine lenders assess the qualifications of prospective borrowers differently from sources of senior debt. 

Due to the ability to foreclose on the property itself in the event of a default, senior lenders are very concerned with the value of the asset itself. 

Mezzanine lenders, on the other hand, cannot rely on foreclosure to recoup any losses in the event of a default and instead use the property’s earnings before interest, taxes, depreciation, and amortization (EBITDA) as a measuring stick to determine if the purchase qualifies for lending.  

Remember that your senior lender will have some threshold of a minimum amount of equity needed in the deal in order for them to lend (a common amount is 15%). 

When you take on a mezzanine loan, you are reducing your equity amount and need to be careful that you still have sufficient equity to meet the qualifications of the senior lender.  

Conclusion

It’s hard to argue with the utility provided by mezzanine debt in the multifamily real estate space.  If you’re having trouble filling up that last bit of equity, you can take on additional leverage through mezzanine debt to get the deal done.  

Despite having its time and place, we tend to avoid mezzanine debt in most circumstances.  As Warren Buffet’s legendary partner Charlie Munger once said, “Smart men go broke three ways – liquor, ladies and leverage.”  One of the guiding principles of our real estate business is to have a healthy respect for debt.  Novice investors pay too little attention to this critical piece and can easily drive themselves over the edge of a leverage cliff. 

Luckily, lenders in real estate tend to do a good job of protecting amateurs due to strict underwriting standards, but the bare minimum is not good enough.  You should aim to be just as skeptical and questioning as your lender when underwriting potential deals – and that includes your sources of capital.

That’s not to say you shouldn’t use mezzanine debt in your own investments.  There are situations where it makes sense and we have utilized it for development projects in the past.  Like preferred equity, mezzanine debt provides an alternative route when you’re facing gaps in funding for your deals.  So long as you don’t over-lever yourself, it can be an extremely useful tool for your real estate business.

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What is Mezzanine Debt for Real Estate Investing?
What is Mezzanine Debt for Real Estate Investing?
What is Mezzanine Debt for Real Estate Investing?
What is Mezzanine Debt for Real Estate Investing?