Mezzanine Financing

Mezzanine financing is a layer of debt that sits between the senior loan and the owners' equity in a project's capital stack. It is repaid after the senior lender but before the equity investors. Because it takes more risk than the senior loan, it carries a higher rate.

In commercial real estate, a mezzanine loan usually isn't secured by the property itself. The senior lender holds the mortgage, and most senior loans forbid a second mortgage. Instead, the mezzanine lender lends to the parent company that owns the property-owning entity, and takes a pledge of the parent's ownership stake. Lenders typically perfect that claim with a UCC-1 filing, and often also by holding the ownership certificates. If the borrower defaults, the mezzanine lender can foreclose on the ownership stake under the Uniform Commercial Code (UCC), which is often faster than a real estate foreclosure. It then controls the property, still subject to the senior loan.

Here is an example with round, hypothetical numbers. A property is worth $10,000,000. The senior lender lends at 65 percent loan-to-value (LTV), or $6,500,000. A mezzanine lender adds $1,500,000, bringing total leverage to 80 percent. The sponsor puts in $2,000,000 of equity.

Why it matters for lenders

For the mezzanine lender, everything depends on the senior loan. If the property loses value, the equity absorbs losses first, then the mezzanine loan, then the senior lender. An intercreditor agreement between the two lenders sets the rules: who gets paid when, whether the mezzanine lender gets notice of a senior default and a chance to fix it, limits on foreclosure, and often a right to buy out the senior loan.

For a senior lender, mezzanine debt raises total leverage on the project even though its own lien doesn't change. Higher total leverage means less cushion and more pressure on the borrower. Senior lenders often cap combined loan-to-value or loan-to-cost (LTC) and approve the mezzanine lender in advance.

Mezzanine debt is often compared with preferred equity, which is an ownership stake with a priority return rather than a loan.

How it works in practice

A debt fund makes a mezzanine loan on a hotel renovation. At closing, its loan administrator records the senior loan terms, the intercreditor agreement's notice and cure deadlines, and the pledged ownership stake. Each month she tracks senior loan payments, reserve balances held by the senior lender, and the hotel's operating results.

When the senior servicer sends a default notice, the clock starts. The fund has a set number of days to cure the default or buy the senior loan. If those deadlines sit in a PDF instead of on the loan record, the fund can lose its best option before anyone notices.