SS146: What is Mezzanine Debt

SS146: What is Mezzanine Debt

Within the capital stack realm of equity and debt, there are many different financing solutions for investors. In this episode, Charles discusses mezzanine debt, what it is, and when it is used by investors.

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Talking Points:

·  Mezzanine financing is a hybrid type of financing that incorporates the features of both debt and equity financing. It provides lenders with the ability to convert their loan into equity in the case of a default – after all other senior debts have been paid off.

·  In episode ss118, we spoke about the capital stack in depth but in short, when you are purchasing commercial real estate, there are typically 2 main parts of the capital stack. The senior debt, or first mortgage, and the common equity, the owner’s equity.

o   For example; you are purchasing a commercial property and you are getting a loan for 70% of the purchase price, and the rest of the purchase price or capital stack (the 30%) is provided by the investors, the new owners. In this scenario, there are 2 parts to the capital stack; the senior debt, and the common equity.

o   Mezzo means half or middle in Italian, and when we add mezzanine financing into the mix, this layer of the capital stack is added right between the senior debt, and the common equity. With our prior example, the new capital stack, it might look something like the senior debt still puts in 70%, then there is a layer of mezzanine financing at 10%, and then the common equity investors put in the remaining 20%.

o   The mezzanine financing covers some of the financing that the equity investor would otherwise invest. In other words, it reduces what the investor needs to bring to the closing table.

·  Mezzanine financing helps to bridge the gap between debt and equity financing, and since it is a higher risk for the lender, it also commands higher returns, normally ranging from 9% – 13% in real estate, and up to 20% when included in a capital stack of financing the purchase of a business.

· Lenders like mezzanine financing since it can be structured in a number of different ways, and normally it will include embedded options, allowing the lender the ability to take a specific action in the future, like the ability to convert the debt into equity (usually in the case of default).

· Borrowers like mezzanine financing since it reduces the amount that the new owners need to invest into the project. If the “blended rate” of both the senior debt and the mezzanine financing is lower than the potential return anticipated by the investors, the investors will see a much larger return on their investment. The blended rate is the interest charged on multiple layers of debt in the capital stack. If this is less than the anticipated return, investors are able to greatly increase their return when they invest less of their own cash, and borrow more. A riskier, and more advanced investment strategy.

o   Next benefit to the borrower, the interest on mezzanine financing is a tax-deductible expense.

o   Last benefit is that mezzanine financing is much more flexible than regular senior debt. It is not uncommon for mezzanine financing to allow borrowers the ability to roll their interest payments into the loan balance. If a borrower is unable to make the full scheduled interest payment, it is able to roll some or all of the payment into the loan balance.

· Mezzanine financing is most common with large construction projects, large commercial property acquisitions, and leveraged buyouts.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is mezzanine debt.

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Charles:
Mezzanine financing is a hybrid type of financing that incorporates the features of both debt and equity financing. It provides lenders with the ability to confer their loan into equity in case of a default after all other senior debts have been paid off.

Charles:
In episode SS 118, we spoke about the capital stack in depth, but in short, when you’re purchasing commercial real estate, there are typically two main parts of the capital stack, the senior debt or the first mortgage, and the common equity, the owner’s equity. Now, for example, you are purchasing a commercial property and you’re getting a loan for 70% of the purchase price and the rest of the purchase price or capital stack. The 30% is provided by the investors, the new owners. In this scenario, there are two parts to the capital stack, the senior debt and the common equity. Mezzo means half are middle and Italian, and when we add mezzanine financing into the mix, this layer of the capital stack is added right between the senior debt and the common equity. If our prior example, the new capital stack, it might look something like the senior debt still puts in 70%, and then there’s a layer of mezzanine financing at 10%, and then the common equity investors put in the remaining 20%, and the mezzanine financing covers some of the financing that the equity investor would otherwise invest.

Charles:
In other words, it reduces what the investor needs to bring to the closing table. Now, mezzanine financing helps to bridge the gap between debt and equity financing, and since it is a higher risk for the lender, it also commands higher returns, normally ranging from nine to 13% in real estate, and up to 20% would include it in a capital stack of financing the purchase of a business. Lenders like mezzanine financing, since it can be structured in a number of different ways, and normally it will include embedded options, allowing the lender the ability to take a specific action in the future, like the ability to convert the debt into equity, usually in the case of a default. Now, borrowers like mezzanine financing since it reduces the amount the new owners need to invest into the project. If the blended rate of both the senior debt and the mezzanine financing is lower than the potential return anticipated by the investors, the investors will see a much larger return on their investment.

Charles:
The blended rate is the interest charged on multiple layers of dent in the capital stack. If this is less than the anticipated return, investors are able to greatly increase the return when they invest less of their own cash and borrow more, a riskier and more advanced investment strategy. The next benefit to the borrower is the interest on Mezzan financing is a tax deductible expense, and one of the final benefits is that Mezzan financing is much more flexible than regular senior debt. It is not uncommon for mezzanine financing to allow borrowers the ability to roll their interest payments into the loan balance. If a borrower is unable to make the full schedule interest payment, it is able to roll some or all that payment into the loan balance. Mezzanine financing is most common with large construction projects, large commercial property acquisitions and leverage buyouts. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments, and potential show thoughts at globalinvestorspodcast.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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