Commercial Loans: How Mezzanine Debt Closes the Deal

Craig Higdon

This is the answer to a question I received this past week concerning a class of commercial real estate loans called mezzanine debt. If youve never heard of it, dont worry. Its usually used by fairly substantial commercial real estate developers and investors in situations where the existing debt doesnt go far enough to get the property financed. Mezzanine debt is the modern-day equivalent of second trust deeds.

First, you need to understand that modern commercial lenders are a jealous lot: Most of them, whether bank, CMBS* mortgage bank, and sometimes life insurance companies wont allow a junior lien to be recorded against a property where they have a first trust deed. There are several reasons for this, but the bottom line is that real estate investors would have needed a great deal of cash to get larger transactions done until the mezzanine lenders showed up. Heres an example:

A real estate investor has owned a large shopping center for 5 years and wants to sell it. When he bought it, he got a 75% LTV loan of $6 Million on his $8 Million purchase price using a Conduit* loan from a mortgage bank. Rates went down from the time he bought it, and it has appreciated to $16 Million in the same time, and his commercial loan balance is now $5.5 Million. Because this is a Conduit loan, our seller would face a prepayment penalty in the range of $600,000 to $1 Million! And since they dont allow second trust deed on the property, the Buyer would have to come up with over $10.5 Million to buy it! Not.

Mezzanine mortgage lenders get around this problem by lending on collateral other than the property. Commercial loan Conduits require borrowers to create a special entity, usually a LLC, to own the property to protect them in the event the borrower files for bankruptcy. The Mezzanine mortgage lender uses the membership interests of the LLC as collateral for their loan instead of the property. So in our example, the Mezzanine lender steps up with a loan as large as $7.3 Million (this would bring the combined loans to 80% of the purchase price), depending upon the lenders debt service requirements. Voila! Purchase accomplished!

Mezzanine lenders also play an important role in large construction loans, too. Unfortunately, these types of commercial loans arent available to regular mortals. The smallest Mezzanine loans tend to be in the $2 Million the $3 Million range. But its good to know theyre there when you do need one!

*CMBS: Commercial Mortgage Backed Securities, usually arranged by major Wall Street investment banks who are referred to as conduits.

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