Mezzanine Financing in Relation to CMBS Loans
Since CMBS loans typically prohibit second mortgages, many borrowers have turned to mezzanine financing to fill in the gap. Mezzanine financing, unlike a traditional second mortgage, is a hybrid of debt and equity that permits the lender to convert their debt into shares in the borrower’s company in the case of a loan default.
Mezzanine Loans Can Provide CMBS Borrowers Additional Financing
Since CMBS loans typically prohibit second mortgages, many borrowers have turned to mezzanine financing to fill in the gap. Mezzanine financing, unlike a traditional second mortgage, is a hybrid of debt and equity that permits the lender to convert their debt into shares in the borrower’s company in the case of a loan default. Therefore, the mezzanine lender sits between the CMBS lender and the equity shareholders in terms of repayment priority, and is junior to the CMBS lender’s claim on the company’s assets.
Mezzanine Loan Interest Rates and Borrower Requirements
Due to this, mezzanine loans typically have much higher interest rates and fees than CMBS loans and other types of senior commercial real estate mortgages. in order to reduce risk for mezzanine lenders, they often require borrowers to be structured as bankruptcy-remote special purpose entities (SPEs). Bankruptcy-remote SPEs are specifically designed to ensure that, if the individual borrower or the borrower’s parent company files for bankruptcy, the commercial property in question will not be involved. To ensure that this remains the case, mezzanine lenders also sometimes require that independent director or special board member be appointed to the board of the SPE in order to prevent an inappropriate bankruptcy filing.
Mezzanine Loans, Bad Boy Carveouts, and UCC Foreclosures
While in general, mezzanine loans are non-recourse, most lenders will require that at least one financially responsible partner signs a carveout guarantee, with stipulations often referred to as “bad boy carveouts.” This means that, while the mezzanine lender cannot go after the borrower’s personal assets in the case of a ‘normal’ loan default, if they commit certain prohibited actions, their personal assets are fair game. These include:
Financial fraud, such as embezzlement or tax fraud
Misrepresentation of a property’s financial strength
Misuse of insurance proceeds or security deposits
Violating SPE covenants and representations
Filing bankruptcy petitions or other relation
Attempting to take out additional subordinate debt
What is mezzanine financing and how does it relate to CMBS loans?
Mezzanine financing is a hybrid of debt and equity that permits the lender to convert their debt into shares in the borrower’s company in the case of a loan default. It is typically used to fill in the gap when CMBS loans prohibit second mortgages. Before a CMBS borrower can finalize their mezzanine loan, both the original CMBS borrower and the mezzanine lender must typically sign an inter-creditor agreement, defining the rights and responsibilities of each lender to each other. Mezzanine loans typically have much higher interest rates and fees than CMBS loans and other types of senior commercial real estate mortgages. To reduce risk for mezzanine lenders, they often require borrowers to be structured as bankruptcy-remote special purpose entities (SPEs). Bankruptcy-remote SPEs are specifically designed to ensure that, if the individual borrower or the borrower’s parent company files for bankruptcy, the commercial property in question will not be involved. To ensure that this remains the case, mezzanine lenders also sometimes require that independent director or special board member be appointed to the board of the SPE in order to prevent an inappropriate bankruptcy filing.
What are the advantages and disadvantages of mezzanine financing?
The advantages of mezzanine financing include flexible financing, low probability of losing ownership or control of a property, and quick closing. However, mezzanine debt is riskier due to a lack of collateral from the borrower, so interest rates tend to be higher (10-20%) and more covenants are included. Common convenants might include restrictions on taking cash out of the property as well as a prohibition on obtaining additional financing until the mezzanine loan has been repaid. Mezzanine lenders are usually granted a lien against the entity that owns the property.
The drawbacks of mezzanine debt include higher interest rates, lender-friendly covenants, not allowed or heavily restricted by agency lenders, high fees and additional legal costs, and lenders being granted a lien against the borrowing entity.
What are the eligibility requirements for mezzanine financing?
Mezzanine financing is typically used by merchant builders looking to maximize their IRR while also maximizing leverage since the cost of equity is often more expensive than non-recourse debt. Eligibility requirements for mezzanine financing vary depending on the lender, but generally include:
- Minimum loan amount of $2 million
- Term coterminous with the first lien
- Leverage up to 90% LTV on stabilized property and 85% LTC on construction
- Interest only amortization
- Nonrecourse options available
For more information, please visit www.commercialrealestate.loans/mezzanine-financing and apartment.loans/posts/what-is-mezzanine-financing.
What are the typical terms and conditions of mezzanine financing?
Mezzanine financing typically has a minimum loan amount of $2 million and a term coterminous with the first lien. Leverage can be up to 90% Loan-to-Value (LTV) on stabilized property and 85% Loan-to-Cost (LTC) on construction. Amortization is interest only and nonrecourse options are available. Fees are typically 3-6%.
For apartment properties, mezzanine financing typically has a minimum loan amount of $3 million and a term coterminous with the first lien (typically between 5-7 years). Interest rates are typically between 9-16% (interest only). Fees are typically 3-6%. Maximum Loan-to-Cost (LTC) is 85%.
Advantages of mezzanine financing include increased leverage and IRR, tax-deductible interest, and flexible options such as equity kickers for reduced interest rates and PIK toggles for reduced interest payments.
Disadvantages of mezzanine financing include high costs (up to 20% for some borrowers), not being allowed by all lenders, and high fees and additional legal costs.
What are the risks associated with mezzanine financing?
The risks associated with mezzanine financing include higher interest rates, lender-friendly covenants, not being allowed or heavily restricted by agency lenders, high fees and additional legal costs, and lenders being granted a lien against the borrowing entity.
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In addition, it may be important to note that if a property with a mezzanine loan does go into foreclosure, it will typically not do so through the traditional process. Instead, mezzanine loan foreclosures are usually enforced under the Uniform Commercial Code (UCC). While this means that foreclosure process has more rules that need to be followed, in general, UCC foreclosures are faster and less expensive than regular commercial mortgage foreclosures.
Mezzanine Loans and Inter-creditor Agreements
Before a CMBS borrower can finalize their mezzanine loan, both the original CMBS borrower and the mezzanine lender must typically sign an inter-creditor agreement, defining the rights and responsibilities of each lender to each other. While the borrower may not be directly involved in this signing, the agreement can significantly affect them, so they should understand what, if anything, is changing for them in the agreement.
Mezzanine Loans vs. Preferred Equity
Unlike mezzanine loans, preferred equity involves a “lender” who actually invests directly in the property, gaining a “preferred” equity stake in the asset. This means that the preferred equity will be repaid before any of the common equity investors. However, just like mezzanine lenders, preferred equity investors still rank behind the CMBS lender, who will be repaid first in the case of a loan default.
In some cases, mezzanine lenders are offering borrowers deals that beginning to look more and more like preferred equity. For example, a mezzanine lender may agree to reduce their interest rates and fees for a certain portion of a property’s annual profits.