Do you want to learn how to get preapproved for mezzanine financing commercial real estate? If yes, then you need to read this guide!
Commercial real estate loans are often used to finance construction projects. However, they can also purchase existing properties. These types of loans are known as mezzanine financing because they usually involve two layers of debt. The first layer is secured against the property itself, while the second layer is unsecured.
In this article, I will show you how to get preapproved and how it works.
How Does Mezzanine Debt Work in Real Estate in November 2022?
Mezzanine finance allows borrowers to tap into additional capital sources to make deals happen. It fills the gap between what the senior lenders will provide and what the borrower needs to close the deal.
In order to make sure you understand how to calculate the return on investment, let’s look at an example using a $1 million purchase of commercial real estate generating $100,000 of net operating income. We’ll assume the investor gets a loan of $600,000, which represents a 5% interest rate, and we’ll use the following formula to calculate the return on equity :
ROE Net Operating Income / Equity / 0.167
If the investor were to invest $600,000 in this deal, she’d receive a ROE of 16.7%.
In order to fund the $400,000 purchase price, the investor must earn $70,000 in annual pre-tax returns on their $400,000 investment. Assuming that the borrower makes the same amount each year, they take five years to pay off the $400,000 loan at an 8 percent annual interest rate. At the end of that time, the investor will have paid $40,000 more than what they originally invested. That means the investor will end up with a total net worth of $480,000, instead of the original $400,000.
The Benefits of Mezzanine Financing in
Mezzanine financings reduce the amount of equity needed by borrowers. In addition, they increase the return on equity invested. This makes them popular among investors because they get more money back than what they put into the investment.
Mezzanines are investments that offer lenders both lower risk and higher returns. These loans have a higher priority in the event of a default.
Borrowers who want to borrow money but do not want to take on the full burden of ownership typically use mezzanine loans. These loans are often used by businesses that need to finance growth or acquisition needs.
This type of financing can provide more generous returns compared to typical corporate debt, often paying between 12% and 20% a year. (investopedia.com)
How to Determine Whether Mezzanine Financing is the Right Choice
Investors often use mezzanine financing to reduce the amount of equity needed to finance a purchase. However, it can increase the leverage ratio of the asset and cut both ways, as it increases profit when the investment pays off and decreases profit when the investment loses money. It also raises the risk of losing everything invested.
Where is Mezzanine Debt Used in Real Estate Investments?
In the above example, the mezzanine lender had to pay $28,000 more than if he had used the senior lender alone. However, the sponsor could borrow $400,000 instead of $300,000. He also saved $8,000 in annual interest payments.
The property is sold after three years for $1.1M. With 70% Leverage Equity multiple, returns are 1.55X. With 80% Leverage Equity multiple returns are 1.71X.
In most cases, sponsors use senior debt to finance up 70% of the purchase price, depending on what a bank will allow. However, if a sponsor does not want to raise equity for the remaining 30%, they may get mezzanine debt for a portion of the remaining capital flows needed.
Mezzanine loans are used to provide additional financing to companies that may need more cash than what they can raise through traditional debt or equity offerings. Mezzanines are often used by companies to help them complete large acquisitions. Companies use them to acquire other businesses, such as mergers and acquisitions. Mezzanine loans also provide a source of funding for companies seeking to expand geographically or enter new markets.
In order to free up additional capital for other investment, create liquidity to return capital to investor or make property improvement. Although adding more leverage to a capital stack with mezzanine debt may add risk for investors, the leveraged level of risk may depend on the investment strategy.
Mezzanine debt secured by a senior construction or bridge loan might be less risky than mezzanine debt secured by a value add project or ground-up development.
The primary focus of a business plan for a stabilized asset is to maintain occupancy and to achieve market rent, whereas a business plan for a value-add or opportunistic deal is to complete the project first and then lease it up, which is inherently riskier.
Mezzanine debt holders’ investments in mezzanines are considered to be less risky than other forms of debt because the real estate collateral secures them. In addition, they are often treated differently under bankruptcy law.
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What Collateral Must Be Provided by Borrowers Who Use Mezzanines to Secure Debt Financing?
Mezzanine loans are unsecured debts that are typically used as working capital or to finance acquisitions. Mezzanine debt does not require the same level of creditworthiness as senior debt.
While this gives mezzo-debt holders recourse in the event the borrower defaults on the mezzanine loan, they will still have to pay the senior debt and will be subject to the senior loan payment obligations. They sometimes call mezzanine loans preferred equity because they represent a kind of investment that is somewhere between debt and equity.
Mezzanine lenders typically invest money as preferred stock or warrants for preferred stock. Unlike mezzanine debt, however, preferred equity does not give them any rights to foreclose on the underlying assets if the company fails. Preferred equity instead represents a share of ownership in the company.
Preferred stocks are usually issued at a discount to market value, allowing preferred shareholders to take part in upside gains without having to put up cash.
Although mezzanine debt has lower interest rates than common or preferred stock, it still carries more risk for investors. Mezzanine debt holders normally have less risk than common or preferred shareholders because debt has priority over equity shares.
Investing in Mezzanine Debt Versus Common Equity
Equity typically has the highest potential return in a real estate transaction. For example, if a deal is successful, common equity owners may receive large returns from appreciation of property value.
In exchange for taking on greater risk, common equity owners typically carry lower risk than other layers of the capital structure. Common equity owners might lose all the invested capital if the deal fails.
Mezzanine loans are used by borrowers to raise money from investors while retaining control of the assets. In the event of a default, mezzanine creditors can seize the assets of the borrower to make up for the loss. Mezzanine debt holders also typically enjoy higher rates of return than do common equity investors.
Capitalization rates for equity investors have been compressed by a confluence of factors. Increasing demand for multifamily properties is driving up rents. Low interest rates are compressing bond yields.
Rising construction costs are increasing construction cost inflation. As a result, the spread between cap rate and yield has narrowed significantly. Investors looking to take advantage of this situation should consider mezzanine debt as a potential source of investment return.
Demand for Mezzanine Debt
Mezzanine debt investors include private equity firms, hedge funds, family offices, institutional investors, and banks. The most active players in the industry are private equity and venture capital firms.
Private equity firms purchase companies intending to sell them off later at a profit. They often use mezzanine debt to finance their investments. Private equity firms buy distressed properties and then sell them before the economy recovers.
Hedge funds are another type of investor who uses mezzanine financing. Senior debt financing allows hedge funds to borrow money at low rates, but they must pay high interest rates to reduce their exposure to credit risks. Mezzanine financing provides an alternative to senior debt that reduces exposure to credit risk.
Family offices are individuals who manage wealth. Family office managers seek opportunities where they can earn attractive returns through the real estate investment. Subordinated debt is one way they can invest in real estate deals without exposing themselves to too much risk.
Institutional investors, such as pension plans, endowments, foundations, and insurance companies, are also involved in mezzanine debt transactions. These types of institutions look for ways to diversify their portfolios and avoid excessive concentrations of risk. Mezzanine lending offers these institutions access to a real estate mezzanine loan that would otherwise be difficult to get.
Debt service payments are made monthly or quarterly, depending on the terms of the loan agreement. Interest payments are due semi-annually.
The following sections provide more information about the different mezzanine debt available:
- Senior Secured Loans
A senior secured loan is backed by collateral . If the borrower defaults, lenders can seize the collateral to satisfy the lender’s claim. Lenders usually require a personal guarantee from the borrower.
- Leveraged Buyouts
A leveraged buyout is a transaction involving the acquisition of a company using borrowed cash. Leverage refers to the amount of debt used to fund the deal. A typical leveraged buyout involves borrowing $100 million and purchasing a company for $300 million. This results in a leverage ratio of 3 to 1.
An LBO is like a traditional corporate merger, except that it uses debt instead of equity to gain the target company. In addition, the acquired company is typically recapitalized so that its shareholders receive less than 100 percent of the value of their shares.
It is sometimes referred to as a “leveraging” because the buyer can increase the size of the business by leveraging the assets of the target company. Leveraging increases the amount of debt required to make the acquisition.
In an leveraged buyout, the acquiring firm will often assume existing debt obligations of the target company. Debt service payments are made monthly. The acquiring firm may also take over the management of the target company.
- Mezzanine Financing
Mezzanine financing is a term applied to loans between junior and senior creditors. It is not considered part of the capital structure of the borrower. Mezzanine debt is unsecured and does not have priority over other debts.
Mezzanines are usually provided to help bridge the gap between debt and equity.
However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year, and sometimes as high as 30%. (investopedia.com)
Legal Aspects of Mezzanine Debt
Mezzanine loans require additional payments above that of a senior loan. If there is a drop in cash flow, the borrower can still pay the senior loan, but there isn’t enough cash left to pay the mezzanine loan.
Mezzanine loans are typically used as a bridge to allow a company to grow while still being financed by a bank. These types of loans are often used to fund start up companies, but also by larger corporations looking to expand into new areas. Because of this, many times the terms of the loan can vary greatly. However, the most common term is anywhere from 5 to 10 years.
In the event of default, the junior lender takes over the borrower’s interest and negotiates with the senior lender to “cure” any outstanding defaults.
Conclusion for Mezzanine Loan Real Estate
The market for mezzanine capital has been growing rapidly. There are several reasons this is happening. First, banks are becoming increasingly risk-averse because of the regulatory environment. Second, there is a need for growth capital in order to fuel economic expansion. Third, businesses are reducing costs through outsourcing and offshoring. Fourth, businesses are looking to diversify their sources of income. Fifth, businesses want to avoid bankruptcy and improve their credit ratings.
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