How Are Mezzanine Loans Used?

Mezzanine loans provide equity or funding to a property owner (other than a homeowner) that has wishes to buy real estate or construct a building. A mezzanine loan is a form of subordinated debt that is based on a primary loan. The difference in loan and equity value forms the basis for a mezzanine loan, which is secured by land, stock or other forms of collateral.

How Mezzanine Loans are Used

Mezzanine loans or financing are common in corporate finance deals. The types of transactions that use mezzanine loans are stabilized properties, value-add financing and financing for new development projects. Each of these uses has their own complexity and structure, which will be discussed briefly below.

Stabilized Properties

In the case of stabilized properties, the mezzanine loan is a debt instrument that is subordinate or secondary to a senior loan on the property. This arrangement has no equity component to it for the lender.

Stabilized property mezzanine loans are the most common financing used in real estate transactions by lenders and borrowers. It has a low risk component and is a straightforward arrangement for borrowers and lenders to understand.

The property being financed with a mezzanine loan needs to generate an income flow that is sufficient to pay its obligations. This includes the debt service on the senior note as well as the subordinated mezzanine loan. The income cash flow must also be able to pay operating costs and generate some income return for the owner of the property.

Value-Add Financing

Value-add financing is the option used for properties that do not have a stabilized cash flow. A recent for this may be that the property is in need of repairs or improvements in order to generate income for the owner. This financing looks at the income opportunity posed by the development of the property using a risk-return analysis.

A mezzanine loan of this type presents a greater risk for the lender. This is because the experience of the borrower to produce income from a “distressed” property sufficient income is what is important. The lender will analyze a borrower’s credentials and verify that they have the required expertise to create an income opportunity before entering into this arrangement.

New Development Financing

A new development mezzanine loan has the highest degree of risk. This is because the funding is being used to create a new development such as an office building, shopping mall or other type of large scale development that has no record of accomplishment. The lender will engage in extensive due diligence to determine the viability of the project and determine the feasibility of providing financing for a new development.