Mezzanine Loans vs Traditional Second Mortgage

Developers and property owners use mezzanine loans as a way to finance the building of large real estate projects. Mezzanine loans are a subordinate debt that leverages the equity in a property in order to provide funds necessary to rehabilitate, develop or engage in a new construction project on the property.

The Basis for Mezzanine Loans

Mezzanine loans are based on a first mortgage or senior debt on the property. The loan is made in an amount of up to 85 to 90 percent of the loan-to-value (LTV) in the property. The amount available depends on the type of project being financed and the relative LTV on the property being financed.  

The Use of a Mezzanine Loan

A mezzanine loan is used to provide funds for a stabilized or existing income producing project, value-add from a non-stabilized project or new development and construction. The level of risk associated with each level of mezzanine financing is shared between the lender and the borrower who receives the proceeds of the mezzanine loan.

Mezzanine Loan Security

A borrower secures the loan using income generated from the existing or new project. The borrower may also pledge shares of preferred stock of the company. This gives the lender an equity stake in the company and dividends as a form of income. The company may also issue participating notes that are an equity/debt instrument. The note pays an interest rate during the term of the loan and the principal amount upon retirement of the debt.

Traditional Second Mortgage Loans

A traditional second mortgage differs from mezzanine loans. A second mortgage is an additional debt incurred on the property that is subject to foreclosure by the lender. This occurs of the borrower is unable to repay the loan. A second mortgage does not have the ability to participate in equity, like a mezzanine loan. It is not secured with dividend paying preferred stock nor are participating notes issued.  

A business qualifies for a second mortgage loan in the same manner that they qualified for the senior loan. The terms and rates of the loan are based on the credit quality of the borrower and are not based on revenue or the income from any project that results from the use of the loan’s proceeds. The terms of the loan are fixed and set in the loan agreement and must be met by the borrower in order to avoid loan default and foreclosure proceedings.