“Mezzanine” finance is a bit like it sounds – 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; the 2nd floor is straight (common) equity; and mezzanine financing is every other imaginable financing in between.
What is it?
Among other things, mezzanine financing can be:
- Any type of junior debt – whether holding the 2nd, 5th, or a completely unsecured position
- Preferred equity – with specified rights above common equity, but effectively below senior debt
- Convertible debt – debt that converts into common equity at specific terms
- Participating debt – interest payments are combined with participation in property income above a specified level
The bulk of real estate financing is still either straight senior secured debt or common equity. Sometimes, however, sponsors (and investors) prefer to utilize mezzanine financing too. More leverage can be utilized, and in many cases the bulk of the appreciation upside can be retained by the sponsor.
How Does Mezzanine Financing Work?
Typically, transactions utilizing mezzanine financing can be capitalized with a ~70% mortgage, 5-25% of mezzanine financing, and the remainder from the sponsor’s equity. Unlike a mortgage, where the lender can foreclose on the property itself, the security for mezzanine financing is generally a lien or contractual right to take over the sponsor’s membership interests in the title-holding entity. Once the mezzanine financier owns that stock and the associated control rights, it effectively owns the commercial project going forward.
Mezzanine debt, though, has a few disadvantages. Some 1st-position lenders continue to express distaste toward making mortgage loans where mezzanine financing is also in place; at a minimum, they typically seek inter-creditor agreements that clarify the rights of the two lenders. Also, the Uniform Commercial Code (UCC) foreclosure process is tried and true, but it is a little unwieldy – involving, among other things, a “commercially reasonable sale process” that involves an auction-type marketing process. While this can be done inside of 60 days or so, it’s still a bit cumbersome and takes some time and money to orchestrate.
Preferred equity arose as a way to have an automatic, self-exercising structure with direct contractual rights contained in the entity’s operating agreement. Preferred equity also avoids the need of an inter-creditor agreement with the senior lender. Preferred equity further enjoys a better position in any bankruptcy scenario, since equity positions are generally not subject to “automatic stay” or other constraints imposed by bankruptcy law. Preferred equity also lends itself to more complicated features, such as a cash distribution “waterfall” that allows the owner/developer to receive some cash flow distributions while the preferred capital is still outstanding, or even where the preferred investors “participate” in some of the project’s “upside” on top of the otherwise promised return.
Enforcing preferred equity remedies against the sponsor’s equity is in some respects less certain than the UCC process utilized for mezzanine loans. Litigation or arbitration as to whether a preferred equity holder’s remedies have been triggered can result in a delay in enforcement. Properly drafted preferred equity documents, then, typically demand a “bad boy” guaranty under which preferred investors have full recourse against the sponsor/borrower for any spurious challenge to the exercise of the preferred investor’s remedies.
Higher Risk, But Potential Higher Returns
Preferred equity investments are in a 2nd position compared to the primary lender, so they are riskier than participations in a 1st-lien loan. The return rates can be higher, though. RealtyShares, one of the more prominent crowdfunding sites, has historically offered investors in preferred equity projects contractual preferred return rates of 12-16%, as opposed to 8-10% on a 1st-lien business-purpose loan.
The default risk with preferred equity depends largely on the remaining equity “cushion” held by the sponsoring real estate company and the contractual protections surrounding any default. In the owner-occupied residential world, the recovery rates on defaulting 1st and 2nd debt were at one time estimated by Moody’s to be approximately 90% vs. 60%. Conventional mortgages have a very different profile in the commercial market, though; many private equity firms engaging in mezzanine debt or preferred equity investments use the change-of-control rights involved in such financings as part of their overall business plan. They have active asset managers involved in workout situations, so that their investment is salvaged and perhaps even turned around (since oftentimes they end up effectively controlling the equity upside in the project). Crowdfunding companies can be expected to follow the same model.
Preferred Equity Seems Here to Stay
Notwithstanding the post-2008 retrenchment, the past few decades in particular have witnessed a boom in the creation of structures for capital that is junior to the mortgage debt but senior to the owner / developer equity. This need actually increased post-2008 as traditional mortgage lenders tightened up their underwriting standards, leaving sponsoring real estate companies scrambling for available capital. Investors participating in crowdfunding sites like RealtyShares now have the opportunity to provide liquidity and additional capital to sponsoring real estate companies needing to fill the “financing gap” between the senior mortgage debt and the owner’s equity.
A version of this article earlier appeared in a print version of Think Realty.