can supplement the financing of large construction projects.
Mezzanine loans are a risky but potentially high-yield way for lenders to provide capital to established developers and business owners. For borrowers, the loans provide a source of capital for new projects or expansions. They are a relatively new but quickly growing form of debt.
Identification
Mezzanine loans are secured by ownership interests in a company rather than the real estate owned by a company. They are so named because of their ranking in priority of payment, below the payment of senior debt but above equity or common stock. Companies in middle stages of growth often use mezzanine loans to obtain capital for continued growth without having to surrender further equity. When in default, lenders foreclose on the securing stock or membership interests, which usually is much quicker than foreclosing a mortgage.
Features
Because they are not completely backed by equity, mezzanine loans carry high interest rates, usually around 20 percent. The agreements often include an equity component alongside subordinated debt, according to mezzanine loan provider Bond Capital. For example, a portion of the debt's interest might require cash payments at regular intervals while the remainder is financed by ownership options or "pay-in-kind' interest, in which interest owed is added to the principal. Mezzanine loans typically do not carry prepayment penalties.
Function
Mezzanine loans have three typical uses, according to real estate attorney George Blackburne III. One is to finance new construction projects, in which case the mezzanine loan supplements the loan from the commercial construction lender to lower the amount of money the developer must put up. A second use is for business owners with mortgage debt to gain access to capital when the terms or penalty of their mortgage prevents refinancing. The third use is a value-added deal. Investors can use mezzanine loans for property improvements, and because such improvements immediately increase a property's value, mezzanine lenders are willing to offer loans with a high loan-to-value ratio.
Size
Mezzanine loans are complex, requiring heavy lifting by lenders who must sort through relevant property and entity documents. As such, lenders usually require mezzanine loans to have a principal of at least $2 million, according to Katharine Noble of the law firm Jones, Waldo, Holbrook & McDoonough. Lenders will also consider mezzanine loans only for large projects, usually at least $10 million, according to Blackburne. About 150 mezzanine lenders operate in the United States alone as of 2010.
Sources
Mezzanine lending dates back to the 1980s, when most providers were savings and loan associations and insurance companies, according to Bond Capital. Since then, many other types of players have entered the arena: limited partnerships, hedge funds, pension funds and leveraged public funds. Some banks also have established mezzanine lending practices.
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