Mezzanine loans may sound like a confusing financing concept, but they are actually quite simple when effectively broken down. Their application in commercial real estate and other high dollar value financial transactions can help ensure a deal goes through and is more profitable for all parties.
An Introduction to Mezzanine Financing
When a buyer approaches a multimillion dollar transaction, they must often assemble various forms of financing to ensure that they have enough cash pledged to close the deal. The primary source of financing is called senior debt. There may also be secondary and tertiary tiers of financing. The highest tier of financing is a mezzanine loan. Mezzanine loans have a higher interest rate and a shorter repayment period than the other sources of financing. They make up the shortfall between the secured financing obtained by the buyer and the buyer’s own equity in the transaction, or the amount of cash the buyer has invested into the deal.
Delving Into the Details
One of the primary reasons that mezzanine financing can be necessary is that in such transactions, the primary lender is limited to financing no more than 60% of the value of the deal. Because a buyer may not have enough cash to invest in the remaining equity, other sources of financing are needed. A buyer may also not want to have that great of an equity stake in the transaction. It is possible to obtain a greater return on investment with a smaller share of equity, which could benefit both the buyer and the mezzanine lender. These calculations take place during the structuring of the deal, so that the buyer understands how best to maximize their cash flow. In short, mezzanine loans can make a deal more profitable for a buyer.
Risks of Mezzanine Financing
Because a mezzanine loan can be so profitable for the investor, with high interest rates over a short period of time, this sort of financing is also inherently risky. Because it is the highest tier of financing in a deal, the mezzanine lender is last in line to be recoup losses in the event that the owner defaults. That is why a mezzanine loan can be structured to include a share of equity in the deal for the lender. Likewise, mezzanine financing is typically limited to buyers with a long and successful track record of multimillion dollar transactions.
Mezzanine loans are not for low-level investors or startup businesses, but they have a definite place in the world of high finance and complex transactions. While inherently risky, this type of financing can be used to great advantage for both borrower and lender.