Capital Structure Mastery Lesson 03

Lesson Three: Mezzanine Financier

There are three defining features of all real estate debt. These three features are the key drivers of the transaction’s risk profile. The riskier the profile, the higher the yield requirement will be. In this lesson, we will focus on Mezzanine debt.

3.1 Mezzanine Debt Overview

As we mentioned in the introduction, there are three defining features of all real estate debt. The first feature is Security/Collateral. With this feature, we are concerned with what the lender’s security is and what the lender will be taking as collateral to secure the loan. The second feature is the Order or Preference of Repayment. The main concern of this feature is when the cash flow will be available and what the order of repayment will be (such as who is paid first, second, etc.) The third feature is Default Remedies. In this feature, we are concerned with lender/investor options in event of a default. These three features are the key drivers of the transaction’s risk profile. The riskier the profile, the higher the yield requirement will be.

Different Types of Debt Products

There are three different types of debt products for commercial real estate. The first is senior debt. This is also known as first trust debt. This product is secured by a first trust and has first priority in terms of cash flow and repayment. The first trust lender’s remedy is foreclosure of the collateral.

The second debt product is mezzanine debt. In its simplest terms, mezzanine lending is the “middle” or “gap” piece of financing between first trust debt and borrowed equity. Mezzanine lending can be described by a variety of names including subordinate debt (because it is subordinate to first trust debt) and junior debt (a generic term for all mezzanine or second trust debt). The term junior debt is less descriptive because it doesn’t tell us anything about rights or security instruments.

The third debt product is second trust debt. This is a common product in residential finance, though less common in commercial real estate. A second trust loan is similar to a mezzanine loan, with the major difference being the security or collateral. A second trust has a recorded lien on the title of the property, whereas—in most cases—a Mezzanine loan does not.

The Intercreditor Agreement

Mezzanine loans that have Assessment of Partnership Interests as collateral will have an Intercreditor Agreement. This is an agreement describing how the first trust lender and the mezzanine lender will interact with one another. There are three major things the mezzanine lender looks for in an Intercreditor Agreement.

  1. Right of Notice to a First Trust Note: The mezzanine lender needs advanced notice from the first trust lender that a default has occurred. This allows the mezzanine lender to know that there is a potential problem.
  2. Right to Foreclosure, to “Step Into the Borrower’s Shoes,” or Replace the Borrower in the Event of Default: An assumption of the first trust loan by the mezzanine lender. In the event of a default and a foreclosure of the mezzanine loan, the mezzanine lender will have the option to repay the first trust loan at par. This is desirable, as the mezzanine lender will not have to find additional dollars to pay off the first trust loan.
  3. Right to Cure the Default on a First Trust Note: This right allows the mezzanine lender to keep the first trust current or in good standing. This is known as a “protective advance,” allowing the first trust loan to remain current and avoid a foreclosure. Protective advances are added to the balance of the mezzanine loan principal.
3.2 Mezzanine Loan Collateral

For mezzanine collateral, there are two main options. The first option is the second deed of trust. This is considered the best form of security because it is a recorded lien. However, most first trust lenders will not allow the mezzanine lender to take the second deed of trust. This deed provides the lender with a recorded interest in the property. A second trust deed is most desirable, but also the most difficult to obtain. Most lenders will not allow a second trust lien on the property because  the second lender is a liability in the case of a bankruptcy. Most transactions today utilize a Special Purpose Entity (SPE) structure, which limits the amount of secured creditors, since senior lenders want full control in case of bankruptcy.

If a deed cannot be obtained, the next best item is the cash flow note. A cash flow note will entitle the lender to project cash flow, although it is generally not a recorded instrument. A cash flow note does not have an Intercreditor Agreement, so the cash flow note holder does not have any rights. There is no collateral, so a lender cannot foreclose.

Another option is the Assignment of Partnership Interests, which is the most common type of mezzanine loan collateral. This typically involves a 100% assignment, although in some cases less than 100% is required. There is no collateral, and it is used in equity transactions. This is not considered a debt instrument. Most mezzanine loans are typically secured by the assignment of partnership interests, which means that if there is a default on the mezzanine loan, the mezzanine lender can “step into the shoes” of the general partner or managing member. If a default occurs, the mezzanine lender will pay off the first trust loan and become the senior lender. This is also easy to enforce. The process is known as a UCC foreclosure. In this case, the lender would now own all of the assets and liabilities, and they would assume the operational risk of the specific project.

Similar to the Assignment is the Partnership Agreement. The Partnership Agreement is used for preferred equity and equity transactions. This is not a loan, but a joint venture, and it determines the economics, the preferences, and the remedies different classes of equity.

3.3 Mezzanine Loan Risk/Reward Continuum

The mezzanine lender/investor must pay particular attention to the “type” of first trust loan that is in front of the mezzanine loan in the capital stack. Mezzanine loans are used for stabilized transactions, value added loans, bridge/value added loans, and construction loans. Let’s begin with stabilized transactions.

Stabilized properties are much easier to underwrite for a mezzanine investment. A stabilized property can be defined as property that is at least 90% leased and has a well-diversified rent roll. This type of mezzanine lending is the most common at the time of origination of a long-term, fixed rate, first trust loan.

Mezzanine investments on value-added or construction properties are more difficult to underwrite. Cash flows are not stable here, and typically the repayment is contingent upon something “good” happening at the property level that will increase property cash flow. In these situations, the lender must underwrite the property as a market level “event” which will lead to an increase in Net Operating Income (NOI).

The mezzanine loan that is the hardest to underwrite and is the riskiest overall is the value-added mezzanine loan behind a floating rate first trust loan. In this case, the mezzanine lender must underwrite the value-added plan of the property, the interest rate risk of the first trust, and the interest rate risk of the mezzanine loan.

Mezzanine loans on construction loans combine all the possible risks of mezzanine lending. The first is the interest rate risk. Construction loans are floating rate loans. The second is cost overrun risk. If construction is over budget, the mezzanine lender’s position in the capital stack increases.

Below is a graphic showcasing what borrowers and lenders want in the mezzanine loan transaction: