Commercial mezzanine loans are more complex but offer a higher return than first mortgages. Most mezzanine loans are a form of a hybrid loan. While they are subordinate to a first mortgage, mezzanine loans are superior to the property owner’s equity. Often the hybrid definition involves the loan being secured by more than the value of the real estate. Because these are second tier to the first mortgage, additional security is pledged in the form of business equipment and/or inventory and stock or something else.
They really are not extremely complex. However, what makes them seem complex is they are often for large amounts of money, structured differently than traditional loans, and use terminology different from traditional lending sources.
Structuring a Mezzanine Loan
You’ll come across the term “capital stack”. This is language used to describe the order that lenders and property owners are entitled to cash flow from the commercial property. Typically, this would be the first mortgage lender followed by a mezzanine loan and the last claim to cash flow is the property owner with equity in the commercial property.
Some real estate investors over simplify mezzanine loans by describing them as a second mortgage. It’s important to understand these are more than a second mortgage. If you own a commercial property and are looking to take out some of your equity or need more working capital, you need to understand how a mezzanine loan works.
Typically, commercial first mortgages have clauses that second mortgages are not allowed on the property. Even if they don’t have a specific clause about this, they effectively accomplish it with low loan to value (LTV) percentages like 70%. That is the incentive that created mezzanine loans because many are not secured by the commercial property.
There are several ways that mezzanine debt is structured. One common way is for the lender to be secured in some way by the equity the owner has in the property. This can be done by directly partnering with the property owner to side-skirt the no second mortgage clause. Essentially the mezzanine lender becomes a part owner in the corporation or LLC that owns the property. Part of the contract will entitle the mezzanine lender to a portion of the cash flow from the property. Once the first mortgage is paid, the mezzanine lender takes their payment before the owner is entitled to the remaining cash.
Mezzanine Lenders Take Some Control of the Property
The owner gives up a large degree of control of the property. Typically, the mezzanine lender assumes the right to be part of important decisions. For instance, if the property defaults on the first loan, the mezzanine lender can restore the first loan and take over full management and possibly ownership of the property.
A less invasive way to structure a mezzanine loan is to secure it with the property owner’s stock shares in either the corporation or LLC that owns the property. In this structure, the mezzanine lender does not actually partner with the owner. Still, there will be clauses in the contract that includes the mezzanine lender in major business decisions. Ultimately, if the loan is not repaid, the mezzanine lender is able to take ownership of the corporation or LLC by foreclosing on the owner’s stock shares. This is easier than foreclosing on real estate property. However, the mezzanine lender is still in a junior position to the first mortgage because the first mortgage can foreclose on the property even if it is now owned and operated by the mezzanine lender.
Since mezzanine lenders are taking more risk, you can expect to pay higher interest rates for these loans. And you, as the property owner, are taking more risk as well when you risk both your equity in the property and control of your business. However, mezzanine loans can be a great source of funds when you need them to grow your business.
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Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.