Commercial real estate investments commonly use mezzanine debt, also called subordinated debt, to boost levered returns. It is one of the four main components of the real estate capital stack, along with senior debt, preferred equity, and common equity. The real estate capital stack incorporates the different types of funding used to finance commercial real estate projects. It also indicates their hierarchy and related order of distributing property income and profits. In this respect, senior debt, which is at the bottom of the stake, takes priority over mezzanine debt that sits on top of it, and mezzanine debt takes priority over preferred equity, which is above it. The intermediate position of mezzanine debt between senior debt and preferred equity has endowed it with hybrid character. It possesses features of both debts and investments while having several distinctions. Mezzanine debt has interest rates and maturity dates like senior debt. However, its interest rates are higher. Also, unlike senior debt that has the underlying property as collateral, mezzanine debt is secured by a pledge of interest in the entity that owns the property.

1. MEZZANINE DEBT IN REAL ESTATE
INVESTING - FEATURES AND
APPLICATIONS
Stuart Hansen

2. INTRODUCTION
Commercial real estate investments commonly use mezzanine debt,
also called subordinated debt, to boost levered returns. It is one of the
four main components of the real estate capital stack, along with
senior debt, preferred equity, and common equity.

3. The real estate capital stack incorporates the different types of
funding used to finance commercial real estate projects. It also
indicates their hierarchy and related order of distributing property
income and profits. In this respect, senior debt, which is at the
bottom of the stake, takes priority over mezzanine debt that sits on
top of it, and mezzanine debt takes priority over preferred equity,
which is above it.

4. The intermediate position of mezzanine debt between senior debt
and preferred equity has endowed it with hybrid character. It
possesses features of both debts and investments while having
several distinctions.

5. Mezzanine debt has interest rates and maturity dates like senior
debt. However, its interest rates are higher. Also, unlike senior
debt that has the underlying property as collateral, mezzanine
debt is secured by a pledge of interest in the entity that owns the
property.

6. In case of failed payments on a senior loan, its holders can
foreclose on the property. In case of unmet payments on a
mezzanine loan, its holders have the right to foreclose on the
pledge and seize ownership of the entity owning the property.
While this collateral secures mezzanine debt holders if the
borrowers default, it also obliges them to continue the payments on
the senior loan.

7. Similar to preferred equity that sits on top of it, mezzanine debt
holders receive interest payments on their investment for a fixed
period. But preferred equity lacks mezzanine’s collateral, which
makes the latter a less risky type of funding.

8. Senior debt usually accounts for 70 percent of the total funding
required to finance a commercial real estate project. A sponsor
then must decide whether to fund the remaining 30 percent
entirely with equity or pursue a mezzanine debt. One of the main
reasons sponsors may choose the latter option is that mezzanine
debt enables them to simultaneously reduce the amount of the
more risky equity in a single transaction and boost their levered
returns. For example, a sponsor may get a mezzanine debt to fund
an additional 10 percent of the project, leaving only 20 percent of
the total finances to equity.

9. Releasing capital for other investments or increasing liquidity to
return capital to investors or perform improvements on the given
real estate are also among the reasons why sponsors may opt for
mezzanine debt.

10. Increasing the real estate capital stack’s debt-to-equity ratio with
mezzanine debt may heighten the risk for investors. However, the
chosen investment strategy is what could influence the level of
risk.

11. For example, some may find that mezzanine debt with a senior
construction or bridge loan possibly collateralized by a value-add
project or ground-up development carries a higher risk than
mezzanine debt behind a permanent senior loan secured by a
stabilized core asset. The reason is, value-add or opportunistic
deals’ primary business goal is to finalize the project and lease it,
which naturally involves higher risk. Meanwhile, stabilized asset
businesses aim to keep the occupancy and reach market rents.