Choosing Between Mezzanine and Equity Financing

by : Mark Hasegawa

If you are an owner or a prospective owner of commercial property in need of financing up to 80-90% LTV, it is important to understand the financing options available to you, so that you choose the best option for your project. Mezzanine and Equity financing are two options which will be discussed in this article.

A Mezzanine loan is subordinate to the first mortgage and comes in various forms, and provides financing up to 85-90% of the required capital. The cost of this type of financing fluctuates based upon how high in the capital structure the financing is provided, what kind of asset is being financed, whether it is a stabilized asset or an asset that is being either repositioned (lower) or developed (higher). Mezzanine loans run from 10% for stabilized apartments or stabilized in-fill shopping centers to 18-20% for hotels and value-added plays, condominium conversions and development, and higher for land. The various forms of mezzanine include:

1. Traditional Second Mortgage: This is secured by a second mortgage and is foreclosable. In today's market this type is rarely done, because most first mortgagees don't want to deal with a second mortgagee in the even of foreclosure.

2. Second Mortgage With No Rights to Foreclose: Generally these are given to the seller of the real property. They are paid from available cash flow, but in the even of default, they are not foreclosable. The result of the inability to foreclose gave rise the traditional mezzanine loan.

3. Traditional Mezzanine Loans: These are secured by an assignment of the ownership interest of the borrower. In the even of default, the lender forecloses on the ownership of the borrower and becomes the borrower. An intercreditor and subordination agreement with the senior lender is necessary.

4. Preferred Equity: Here the lender becomes a direct partner in the ownership but has a preferred return and if there is a capital even or an even of default, the lender (equity investor) has a liquidation preference. The lender investor only gets the same preferred returns as if he were a mezzanine lender; he does not share in the residual profits, except there might be an exit fee or other "kicker" if the leverage is high.

5. Equity Structured as Dept: Here an equity investor wants the protection offered to a mezzanine investor, i.e. collateral and because of the collateral (especially if it gets a mortgage), better protection in bankruptcy. Also an equity investor can get better protection if there are environmental liabilities as the result of federal legislation in 1997.

The other financing option for those looking for high LTV financing for their commercial property is equity. True equity comes in various forms. The most important characteristic about equity is that it shares in profits and does not have a "guaranteed return" which if not paid triggers a default, with the consequential loss of equity. It generally finances the riskiest part of the capital structure (sometimes as much as 100% of the capital requirements and generally is seeking returns in excess of 20%. It also has more controls over the operations and decision making of the ownership entity. Various forms include:

1. Typical Equity Structure: This is ownership of the entity, which has title to the property. The investor has a certain amount of control from the right to veto or approve all actions to the right to cause any actions. Generally the more money you invest in a project: (a) the greater control you will have over the project, and (b) the better returns or promote to the owner/developer. Many investors today are seeking IRR based returns. They are seeking preferred returns generally in the 1-15% range depending on asset class and how high up in the capital structure the investor is going. However, other investors are looking for the "big hit" and will only do deals where there is a decent chance at significant upside.

2. Equity structured as Debt: See Above.

3. Promote Structure and Waterfall: Generally institutional investors provide capital and then after achieving certain benchmarks, give the developer additional profit incentives which they call the "Promote." The Promote kicks in after certain specified returns, i.e., after the preference return etc. For example lets say a project will cost $10,000,000 and is projected to earn 15% on cost or $1,200,000,000 upon completion and "rent up": Let's further assume, that the developer is able to secure a construction loan of 75% of cost or $7,500,000. The equity requirement is $2,500,000. The developer will put up 10% of the equity. Let's further assume the project is a project that will be sold at completion. Let's assume it takes on year to build and it takes on year to rent up. Let's assume it's a shopping center and the anchor leases start upon completion and the balance of the leases come in at the end of the second year. Let's further assume the project will sell at an 8% cap rate on the $1,200,000 or $15,000,000 and the income from the anchors is $1,000,000. The first mortgage will cost 6%.

Here is a comparison the advantages of Mezzanine financing vs. Equity Financing:

Advantages to Equity:

1. You usually need less cash

2. In the even of default, there is less risk, you don't have a debt forgiveness tax liability

3. Mezzanine is additional leverage with all its risks

4. In the event of a thinner project than projected you can still make money if there is a profit but the profit is less than the required mezzanine return, and in that even you won't get wiped out.

5. No need for intercreditor and subordination agreement with senior lender.

6. More equity might result in better senior loan terms.

7. Some senior lenders simply don't like mezzanine loans behind them, or won't allow an assignment of the partnership interests.

8. No personal guaranties (as there might be with mezzanine).

9. Usually simpler and quicker to document (and less legal fees).

Advantages to Mezzanine:

1. When the returns are larger, it is generally better to put up more capital and keep a larger portion of the profits.

2. Mezzanine doesn't share in the profits, their return is capped

3. Mezzanine has much less control, of the day-to-day operation; they are a lender with lender controls similar to a first mortgagee (albeit somewhat tighter)

4. The mezzanine investors return requirements are usually less than the equity investor's requirements, (although Preferred Equity returns are similar to mezzanine).

In Summary, for all the reasons that a borrower may prefer equity vs. mezzanine, the lender may have the same or opposite reasons to desire equity vs. mezzanine. Some lenders will just not do equity. Or, they may not be willing to make a distinction between pure equity and preferred equity ("equity is equity"). Also, lenders often have LTC/LTV limits above which they will stop viewing something as mezzanine and start expecting an equity return (e.g. a lender may decide that anything about 90% requires equity returns). The bottom line is that is has to work for both parties.