How Mezzanine Financing Works in Property
Property investing is a popular and relatively secure way to make a return on your investment. However, there are times when deals fall through, or you prefer not to tie up your assets to start a project.
An excellent method to fund your project and move forward is to use mezzanine finance. This method has helped thousands of investors who needed cash to move ahead with plans.
What is Mezzanine Financing?
A mezzanine loan is financing that is a hybrid of debt and equity. Its purpose is to fill the gap between the funding provided by the bank or other lenders and any additional costs. This subordinated debt is based on the projected equity and the assets of the property. Essentially, if you need access to cash so your building project can proceed, you may need mezzanine financing.
How Does Mezzanine Financing Work?
With mezzanine loans, your funding source lends you money at a fixed rate of interest for a finite amount of time that both parties agree upon. Interest on this type of loan will be calculated on day one on the total loan amount. Lenders do this because borrowers generally take possession of the total amount of the loan to start their development.
A mezzanine loan is not considered a secured loan because you do not secure them with the equity you have in your business. How mezzanine finance works in property instead is by permitting the lender to convert the loan’s debt into equity if the terms of the loan are not followed. Generally, the conversion is into stock shares, options, or warrants.
What Are Some Advantages and Disadvantages of Mezzanine Financing for Borrowers?
Advantages for Borrowers:
- Ability to Access Capita – The money a borrower needs is available for them.
- The Benefits of Capital Structuring – Mezzanine loans usually appear as equity on a company balance sheet. This allows the business to appear to have a lower amount of debt.
- There are Several Options for Repayment – Lenders generally accept cash interest payments or add them to the loan.
- Interest Payments Can be Deductible – In many cases, a business can deduct the interest payments.
Disadvantages for Borrowers:
- Risk of Equity Loss – In the event of a default on the loan, equity interests may go to the lender.
- Financial Consequences – A borrower may encounter substantial debts or other financial consequences if things do not turn out as planned.
- Demands from Lenders – Some Mezzanine lenders will set specific conditions that borrowers must meet.
What are Some Advantages and Disadvantages of Mezzanine Financing for Lenders?
Advantages for Lenders:
- Equity and Participation – Lenders have the potential to share in a business’s success by receiving equity
- Interest Income – Higher interest rates are charged to offset the high risks of mezzanine lending.
Disadvantages for Lenders:
- Risk of Loan Default – This is a general risk all lenders experience. However, the chance of experiencing this is greater for mezzanine lenders.
- Low Seniority – There may be little left after a business pays all other debts.
An Example of Mezzanine Financing
If you are planning to buy a commercial real estate property with a value of $1,000,000, you could get financing from a bank. The bank provides a loan of $750,000, and you must front $250,000 of your money for this purchase to go through.
Presume the property earns you $200,000 a year, and $60,000 of that goes to the bank for payments. You have $140,000 profit, and after taxes, roughly $90,000. Ultimately, you have a 36% return on your investment. This is not bad, but you can potentially do better.
By finding a mezzanine investor to put in $150,000, you only have to put in $100,000 of equity into the project. The bank receives $60,000 a year, and your investor gets $27,000. This gives you an after-tax profit of $63,000. But you made a profit from your investment of just $100,000. Your profit is 63%.
If you are wondering if mezzanine financing could be suitable for your next property acquisition or want to learn about your options, feel free to contact our experts at Quantum Capital Australia. We have worked with hundreds of clients to meet their goals and can also help you.
- What is the typical repayment schedule for the mezzanine refinancing?
It is vital to realise that mezzanine financing is a long-term situation. Usually, a mezzanine investor will only require interest payments. This is often the case for three or four years into the loan. This can vary depending on specifics determined by the lender and borrower’s agreement. Generally, you can expect your mezzanine loan to mature in five to seven years.
- What is the difference between a mezzanine loan and a mortgage?
A mortgage is a senior loan that is directly secured by real property, while a mezzanine loan is a subordinate hybrid of debt and equity. It is secured by a pledge of equity
interests in an entity that owns real property.
Additionally, mortgages are restricted by Loan Value Ration (LVR) determined by those governing lending institutions. A mezzanine loan can go up to a 90% LVR, whereas a traditional mortgage will have considerably lower limits.
Due to the greater risk, mezzanine loans have higher interest rates than mortgages.
- Can you prepay mezzanine debt?
Typically, mezzanine debt cannot be prepaid like senior debt can. This is to ensure the returns are sustained. Many will charge penalties for prepayment. If you are in doubt about the terms of your agreement, your investor or a representative can explain.