Mezzanine debt
Also called Mezzanine, Mezzanine loan, Subordinate debt.
Mezzanine debt sits between the senior mortgage and the equity: repaid after the senior loan and before the equity, priced above the mortgage and below equity, and normally secured by a pledge of the ownership interests rather than by a mortgage on the property.
How it works
Its function is to push total leverage past what a senior lender will do without giving away ownership economics to a preferred equity investor or a joint venture partner. A senior at 65 percent plus mezzanine to 78 percent replaces thirteen points of equity with debt priced below a target equity return, which is accretive when the deal performs and painful when it does not.
The security structure is what matters in a workout. Because a mezzanine lender holds a pledge of the equity interests rather than a mortgage, it forecloses on the ownership entity rather than on the real estate, which is faster than a mortgage foreclosure and leaves the senior loan undisturbed. An intercreditor agreement between the two lenders sets out who may do what and when, and it is negotiated between them rather than with the borrower.
The arithmetic to watch is combined coverage. Senior debt service plus mezzanine interest measured against the same NOI produces a number well below the senior lender's own covenant, and on a low cap rate asset it can fall below 1.00x, which means the mezzanine is being serviced out of reserves or out of the sponsor's pocket rather than out of the property. Some structures accrue part of the coupon instead of paying it, which relieves the cash flow and grows the balance the eventual refinance has to clear.
Formula
Combined DSCR = NOI / (senior debt service + mezzanine debt service). Blended cost = combined debt service / total debt- Mezzanine is normally interest only for its term, and some or all of the coupon may accrue rather than pay currently
- Total leverage across both loans is the combined loan-to-value, sometimes written CLTV
- The senior lender has to permit it, and the terms live in an intercreditor agreement rather than in the borrower's loan documents
Worked example
The sample property. Senior $36,335,000 at a 6.35 percent interest-only constant, mezzanine taking total debt to 78 percent of the $55,900,000 price at an 11 percent current-pay rate. NOI $3,020,000, total uses $56,900,000.
| Total debt at 78% of price | $43,602,000 |
|---|---|
| Mezzanine loan | $7,267,000 |
| Mezzanine interest | $799,370 |
| Combined annual debt service | $3,106,642 |
| Equity required, down from $20,565,000 | $13,298,000 |
| Combined debt service coverage | 0.97x |
Coverage on the combined stack is below 1.00x, so the property does not cover its own debt service in year one and the shortfall has to be funded from somewhere else. The blended cost of the two loans is 7.13 percent against a 5.40 percent going-in cap rate, which is 173 basis points of negative leverage before a dollar of principal is repaid.
Conventions worth knowing
- Ask whether the coupon is current pay or accrues. Accrued interest compounds and grows the balance a refinance has to clear.
- Read the intercreditor agreement's cure rights. Whether the mezzanine lender may cure a senior default, and for how long, is what decides a bad year.
The common mistake
Reporting the senior coverage as the deal's coverage
A summary quoting 1.31x on the senior loan while a mezzanine tranche sits behind it is describing one lender's position rather than the property's. The number that matters to the equity is the combined coverage, which on this stack is 0.97x, and the gap between the two is the whole question of whether the deal distributes anything. Model every tranche in the cash flow, report coverage on combined debt service, and test what a covenant breach on either loan does to the other.
Related terms
- Loan to valueLoan to value is the loan amount divided by the property's value, expressed as a percentage. It is the most familiar leverage constraint and, on a purchase, is normally tested against the lesser of the appraised value and the purchase price.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Positive and negative leverageLeverage is positive when the going-in cap rate exceeds the loan constant, so each borrowed dollar earns more as real estate than it costs as debt service and the levered cash return sits above the unlevered one. It is negative when the constant exceeds the cap rate, and then borrowing lowers the current return.
- Bridge loanA bridge loan is short-term, usually floating-rate debt that carries a property while its business plan is executed and is repaid by a sale or a permanent loan at stabilization. It funds capital in draws and carries an interest reserve, because the property cannot yet cover its own debt service.
- Preferred returnA preferred return is a threshold rate of return that limited partners receive on their capital before the general partner participates in profits beyond its own pro rata share. It is a priority in the distribution queue, not a promise that the money will be there.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.