Mezzanine capital is a type of financing that’s comprised of part equity and part debt, which typically allows investors to seek higher than average returns . If you invest in mezzanine capital, you will be able to enjoy the best aspects of senior debt and equity. When looking specifically at the basic capital structure of a building or property, the top of the stack consists of equity holders, which include common equity and preferred equity holders. Below these two levels are mezzanine debt and senior debt.
If you make an investment into a property with senior debt, you take priority over anyone else within the capital stack. When the property performs well, you will be paid before anyone else with the interest payments that are received from the property. If the property doesn’t perform well, senior debt holders can start the foreclosure process or obtain ownership of the property in question. Holders of common equity often take on the most risk since they are paid last, which means that they may not be able to recoup their initial investment if the property fails. However, holders of equity and preferred equity are able to receive higher returns than anyone else in the capital stack. If the property performs well, common equity investors will receive regular payments from the cash flows of the property.
Both mezzanine debt and preferred equity are forms of hybrid capital. While mezzanine debt isn’t secured by the property, it is secured by ownership interest. Holders of mezzanine debt do have some limited foreclosure rights as well. When you’re looking to invest your money into different properties, mezzanine debt often allows you to seek higher interest rates than senior debt holders. This form of debt usually comes with a shorter term of 6-24 months. Since you will also hold some of the borrower’s equity interest, you can foreclose on this portion of the property in the event that the borrower defaults. If you want to get started with real estate investing and are interested in taking on some mezzanine debt, the following article offers up a look at the basics of mezzanine capital.
What is Mezzanine Capital?
Mezzanine capital is a type of financing that’s made up of part equity and part debt. While senior debt holders use the property as collateral, the mezzanine capital investment is made against the property cash flow. Once you invest in mezzanine debt for a specific property, your returns will be largely dependent on the cash flow from the property in order to receive repayment for the principal of the loan.
This typically means that you will need to have patience when dealing with the borrower. While you’re taking on more risk than a senior debt holder, your returns will often be higher and can range from 12-18 percent each year. The equity from this investment usually comes in the form of a warrant, which allows you to purchase actual equity in the property at a later date. If the property happens to be highly successful, the equity that you purchase may provide you with high returns.
The best aspects of mezzanine capital include the regular cash returns that you should receive along with the potential for high returns over the length of the loan. Unlike preferred equity or common equity, this type of investment has low volatility and provides you with some protection in the event that the real estate project fails or the borrower files for bankruptcy. Since around 65 percent of the returns from a mezzanine investment are generated from the contractual interest that the borrower pays, the overall risk of the investment is reduced. Even if you don’t receive any return from the equity that you’ve purchased, most of your initial investment can be recouped with mezzanine capital.
Risks of Mezzanine Debt
There are several risks that you should be aware of when you invest in mezzanine debt. It’s important to understand that a mezzanine debt investment is going to be structured as a long-term investment, which means that there’s less liquidity with this investment type. It’s very difficult to liquidate a mezzanine debt loan until it has reached maturity. If the property fails, senior debt holders will have access to any remaining funds and assets before you.
If the borrower defaults on the property, the only protection that you have comes in the form of the guarantees that you initially received from the borrower. In general, this is the ideal investment type if you want to have a mixture of risk and consistent returns. While senior debt investments are safe, they don’t always garner high returns. If you invest in preferred or common equity, you may be taking on more risk than you’re comfortable with.
The primary characteristics of mezzanine capital include:
- Investment is made against cash flow
- Regular cash payments
- Low volatility
- Extensive downside protection
- High returns
- Potential collaboration with senior debt holders
How Does Mezzanine Capital Work?
If you want to make an investment with a local restaurant, you will first need to identify how much operating income that they receive. Let’s say this operating income is $300,000 per year and that you receive a purchase offer from the owners for $1.2 million. If you don’t have this amount of money in your bank account, you could turn to a senior lender to contribute around $800,000 of the $1.2 million price tag. This would leave you with $400,000 in equity that you would need to pay. If you made this investment, you could receive more than 18 percent in yearly returns.
However, you can choose to reduce this equity by focusing on mezzanine debt. Of the remaining $400,000, you could find a lender to add more leverage above the senior debt holder. If they pitch in $200,000 of the remaining $400,000, this would leave you with $200,000 of equity. The mezzanine lender usually provides this financing at a rate of 12-18 percent per year. While the equity holder will earn less each year because of the interest that needs to be paid to the mezzanine lender, their initial investment can be halved, which allows for less risk.
If you want to make a mezzanine investment, you need to find a project or property where the equity holder is searching for a mezzanine lender. Since you are charging an interest rate for your loan, the returns that you obtain can be paid in any way you see fit. The rate of returns will be set in the initial contract with the borrower. You can mandate that the interest payments be made monthly, quarterly, or annually.
What is the Difference Between Senior and Mezzanine Debt?
The main difference between mezzanine debt and senior debt is that the latter doesn’t include any amount of equity. Senior debt investments usually come with lower returns but also lower risk. While mezzanine debt is lower on the capital stack than preferred equity and common equity, there’s still a considerable amount of risk attached to this form of investment. The main risk difference is in what these loans are backed by. Unlike preferred equity or common equity, there is a kind of collateral available with mezzanine debt and senior debt. However, this type of collateral is very different.
When you make an investment with senior debt, your investment is backed by the actual property you’re investing in, which means that a default on the property would allow you to acquire the property completely as a means of selling it or foreclosing on it. With mezzanine debt, your initial loan is backed solely by the cash flow of the property. Because of the higher risk of this loan type, you will charge the borrower a higher interest rate. With senior debt, the interest rate is close to eight percent. It’s possible for mezzanine debt holders to obtain interest rates of 12-18 percent. The choice that you make depends entirely on what you’re looking for from an investment.
Characteristics of Senior Debt
The main characteristics of senior debt include:
- Prioritized for repayment in the event of bankruptcy
- Lower returns
- Secured by property
- Lowest risk in capital stack
- Regular interest payments
Characteristics of Mezzanine Debt
The main characteristics of mezzanine debt include:
- Potential for high returns
- Backed by property cash flow
- Relatively low volatility
- High-interest rates
- Regular interest payments
- Small amount of downside protection
- Warrants that allow you to purchase equity in the property
How Do I Invest in Mezzanine Debt
When you want to invest in mezzanine debt, there are two primary methods for doing so. You can either negotiate mezzanine debt transaction with a company or invest in a private fund structure that pools investments together for the sole purpose of investing in mezzanine debt. If you’re an individual investor, you should consider the second option. By joining a private-fund structure with many other investors, your risk may be significantly reduced. You may also be able to join the private fund without needing to make a large initial investment.
Mezzanine debt investments that are made directly with the company or company owners typically require that the investors provide a large amount of capital. These direct investments are commonly made via private equity firms, investment banks, or family owners. If you’re a smaller investor, you will likely need to have a relationship with the borrower if you want to be able to invest in mezzanine debt. Otherwise, this type of direct investment is usually reserved for large institutions.
When you want to engage in this type of investment, keep in mind that the negotiation and closing process can take anywhere from a few weeks to a few months. The easiest way to enter the mezzanine debt market is via a private limited partnership, which is usually organized by an asset management firm. They will gather the funds and handle negotiations for obtaining high returns with comparatively lower risk.
Why Your Company Might Choose Mezzanine Financing
If you or your company is considering investing in mezzanine financing, there are numerous reasons why you might want to do so when compared to the other types of financing in a capital stack. The potential returns are high and may provide you with fantastic dividends. Because of the contractual interest return that you will have made with the borrower, the volatility of this type of investment is typically lower. In most cases, the interest rate that’s negotiated when making a mezzanine debt investment is around 15 percent. You should receive interest payments in cash around once per quarter. If you are looking to take on some risk with your investment portfolio but want some amount of protection with your investment, choosing mezzanine financing as your primary form of investment is a good option for your portfolio.
When you want to get started with a mezzanine debt investment, you should first determine how much capital you’re willing to invest. If you’re investing hundreds of thousands of dollars, you could consider directly negotiating with the owners of the property. In the event that your investment is closer to $5,000-$20,000, it may be better to join a private investment management firm that focuses on mezzanine debt. With this approach, your investment will be pooled with other investments and will be managed directly by the private firm.
*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.