MEZZANINE MARKET BASICS
With regulated lenders becoming more conservative, many equity investors are not satisfied with the amount of debt available to finance their properties. Lenders require that the owner provide 30-35% of the value of the property, while many borrowers prefer to limit their equity investments to 10-15% of value. In a stable operating environment, owners find it difficult to contribute a large share of equity and also earn returns on their capital in line with those of the recent past. Mezzanine finance providers deliver additional capital to fill the gap between what the owner wants to borrow and what the first mortgage lender is willing to provide.
In occupying the middle ground, mezzanine finance providers bear greater risk than do first mortgagees, but less risk than equity owners. This reflects the priority of claims on cash flows. First mortgages have first claim on cash flow, mezzanine providers are next in line, and equity investors receive the residual. In the event of borrower default, mezzanine providers have an option to assume the first mortgage obligation. This option must be exercised or the first mortgage lender can foreclose on the mezzanine position and the owner. Alternatively, the mezzanine provider can choose to walk away from the bad investment without the obligations of the original owner (the borrower) or the new owner (the first mortgage lender).
The current pay financing cost of the capital structure increases when mezzanine is introduced and overall debt service coverage ratios decrease and loan-to-value ratios increase. For bearing risk greater than that of first mortgagees, mezzanine finance providers receive an expected return in excess of that of first mortgages, typically in the 8-20%+ range, depending on the part of the capital structure they are providing and the risks inherent in the underlying property.
Mezzanine finance, by definition, defies generalization–there is no typical or standard deal structure. Each financing consists of unique terms and conditions that depend on the preferences of the user and provider and that emerge from a highly negotiated process. The mezzanine piece can be structured as debt or equity, depending on how much capital the owner wants and how much control the owner wants to cede to the mezzanine partner. Second trust debt and junior debt are common names for mezzanine finance, structured as debt, that typically bring the total LTV ratio as high as 85%. Preferred equity and gap equity are common names for equity-type financings that bring the capital structure above 85% LTV.
