A mezzanine loan is debt financing junior to the mortgages in their lien position. In real estate, it is typically used to finance the expansion of existing commercial properties.
“Mezzanine loans are similar to second mortgages,” according to Loans.com, “except a mezzanine loan is secured by the stock of the corporation that owns the property, as opposed to the real estate.”
Benefits of a mezzanine loan for borrowers and lenders
A borrower can increase the amount of capital available to fund a project by taking on a mezzanine loan. This, of course, would be in addition to a mortgage.
The less risk in a real estate transaction, the less interest lenders require. A developer with cash on hand needing only 50% of the capital will probably get an excellent rate. Naturally, this is especially true if it’s secured with a first lien. For the same project, if the developer needs 60%, the lenders will charge a higher rate. Still, it might not be that much higher if they keep their first-lien position. If that developer needs 80%, though, the lenders might refuse to participate by any terms. Ultimately, they might not have the appetite for that level of risk.
But, after first securing a mezzanine loan for 20% of the needed capital, the borrower can now go back to the lenders for that mortgage on the other 60%. The interest rate on the mezzanine loan is likely to be much higher than the interest rate on the mortgage, but at least the funding is in place.
Benefits to the lender extend beyond a higher interest rate. Shares of stock secure a mezzanine loan rather than the real estate itself. Thus, the laws governing foreclosure are less restrictive. Lenders can foreclose in a matter of weeks, rather than the months or years mortgage protections require.
In the capital stack
The capital stack, which ranks the levels of capital by riskiness, has the safest — senior debt — at the bottom and the most speculative — common equity — at the top. One layer up from the bottom is mezzanine debt. This includes the junior loans described here. It can — but doesn’t necessarily — include debt that’s convertible into equity.
Some consider preferred equity to be a form of mezzanine debt.