Mezzanine Financing in Relation to CMBS Loans

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

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.


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