Mezzanine loans are a specialized form of financing that is used in commercial real estate investing. They are similar to a second mortgage on a residential property, as they combine debt and equity financing together. Generally, this type of financing is considered high-risk for borrowers; however, they can offer higher yields, as well as security, for investors. Usually, mezzanine loans is individual real estate investors as a part of a debt investment package.
Mezzanine Loans: An Overview
Mezzanine loans is considered a form of debt that lies between asset-backed debt and corporate equity. Generally, these types of loans are used by real estate investors to secure extra money against a commercial property that they own, above the initial mortgage that was taken out on the property. As an example, an investor could buy a $20 million commercial property and fund it with a $10 million mortgage, $5 million in cash, and a $5 million mezzanine loan. In this example, the mezzanine loan isn’t secured by the property, but rather, the stock of the company that purchased it secures the debt.
Should a mezzanine loan borrower default on the loan, the lender would have the ability to secure the money that they are owed by going after the entire company instead of just the property that the loan was made against.
Examples of Mezzanine Loans
Lenders that provide mortgages for commercial properties, including commercial banks and pension funds, usually limit the amount of a mortgage; 50 percent of the value of the property, for example. In this case, a mezzanine loan could be used as a way to remove equity from a commercial building that is already owned and has a low mortgage-to-value ratio on the initial mortgage. In other words, a mezzanine loan could be used as a way to bridge funding while the building is being renovated, for instance. Once the renovations on the building are complete, the mezzanine loan would be replaced by a new initial mortgage, and that mortgage would be based on the higher property value (which increased, as a result of the renovations).
Features of a Mezzanine Loan
Compared to traditional commercial mortgage, mezzanine loans have shorter terms; typically, the maximum term for this type of loan is five years, whereas the term of a traditional commercial mortgage could be 15 years. Usually, the investor who borrowed the mezzanine loan will only need to make interest payments and when the mezzanine loan matures, the investor would be able to either pay it off or renew it.
Another way in which mezzanine loans differ from traditional commercial loans is in terms of the interest rates. Generally, the interest rates on mezzanine loans are a lot higher on mezzanine loans than they are on traditional commercial mortgages. For example, if the interest rate on the property’s initial mortgage is 4 percent, the interest rate on the mezzanine loan might be 10 percent or more. The minimum amount an investor can use a mezzanine loan to borrow varies and is based on the lender; however, typically, the smallest amount is $1 million to $2 million.
A mezzanine loan combines debt and equity financing. While the rates are higher and the lender does have the ability to go after an entire company if the borrower defaults, this type of loan can be an effective way for real estate investors to secure the financing they require to make changes to an investment property, such as renovations or other improvements. Additionally, compared to other types of loans, mezzanine loans are easy to manage, as borrowers can calculate their interest in the loan balance.
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