How Mezzanine Debt Benefits Commercial Real Estate Investors
Commercial immovable has always been popular because of its attractive risk-reward profiles. To start a business, most real estate investors choose to finance their investments with a down payment and a conventional mortgage. However, many great ideas require securing large funds that cannot always be satisfied with typical financial instruments. So what can help investors bring these ideas to life? Two words: mezzanine debt. But what exactly does this financial instrument mean?
Mezzanine debt helps commercial real estate investors bridge the gap between their equity and the senior debt a lender will provide them. At the same time, it gives them the opportunity to earn a higher rate of return on their investment. Now let’s take a deeper look at what benefits mezzanine financing can offer investors to secure their next real estate adventure.
Features and Benefits of Mezzanine Debt: The first feature and, at the same time, the main advantage of mezzanine debt is that it is additional debt that an investor takes on to finance a commercial real estate business. With its help, they can reduce the amount of equity capital required when jointly securing the financing of an acquisition or expansion project.
In the stack of real estate capital of an investment, mezzanine debt comes just above senior debt. It is generally in the form of subordinated debt; however, it can have an equity component. This subordination means that it is paid after all senior debts have been settled. However, it takes precedence over preferred and common stock in the event of bankruptcy. Once the senior debt and operating expenses are paid, all income must be used to pay off the mezzanine debt afterwards. If the payments are not honored, the mezzanine finance lender has the right to seize the equity position and eventually take over the property and the mortgage.
Even though mezzanine financing has a higher interest rate than senior debt, an investor can earn a higher return rate with this instrument. The yield is often between 12% and 20% per year. Of course, this depends on the risk of the project and the amount of equity the sponsors bring.
Finally, another really important benefit that mezzanine financing offers is the reduction in the capital requirement. An investor does not have to use all of the equity for a single transaction. They can take the loan and use the rest of the equity for another opportunity, taking more advantage of their returns. In another case, the mezzanine loan can come to the aid of those who do not have enough capital but still do not want to miss an opportunity. That way, they don’t have to go to other equity financing partners and dilute their stake.
How can investors significantly benefit from mezzanine financing? As we have seen, mezzanine debt helps bridge the gap between the senior debt financing available to fund a real estate transaction and the equity investors invested in the transaction. Now let’s translate this into a real life scenario …
In a conventional real estate transaction, an investor can typically cover senior debt up to a maximum of 80% of a property’s value. This leaves 20% which must be covered by equity (available cash). For example, an investor likes to buy commercial real estate with a purchase price of $ 1 million. The investor can obtain financing of $ 600,000 for the purchase from a senior lender, which leaves him with an additional capital requirement of $ 400,000 to complete the transaction. Suppose this investor does not have (or, in many situations, does not wish to lock in such a large sum of money) $ 400,000 in capital to engage in this transaction. In this case, they will need to consider alternative financing options.
Let’s take a look at the three most common charts: The first is to attract other equity investors, which means dilution of the shares and less control on the part of the borrower. the property. It is not a preferred option for many experienced investors. The second is to find another source of funding, such as preferred stocks. However, the private lender will give priority to repaying any cash flow or profit made from the investment. Also, it doesn’t seem like a great choice.
The third and best option would be mezzanine financing. The investor can get $ 200,000 in mezzanine financing and return the remaining $ 200,000 in cash. By using this financial instrument, the investor would reduce his need for equity financing while increasing the return on the investment and showing a high-end profit. In addition, mezzanine loans generally do not require payment during the period. duration of the debt, only at the end, allowing the investor to improve his cash flow.
Is Mezzanine Financing Right For Every Transaction? When investing in commercial real estate, investors should be aware of the advantages of mezzanine loans and the benefits they provide. The valuation of all options and financial instruments is necessary in order to obtain maximum gain from any potential real estate business.
Nonetheless, mezzanine financing offers a great way to cover the difference between equity investors who need to close a deal and senior debt financing guaranteed by lenders. And while these loans increase the risk profile of the transaction, they also improve the return potential. Ultimately, the best way to decide if mezzanine debt is the best option for a particular transaction is to weigh the pros and cons of using this financing tool in the special real estate business.