Because mezzanine debt is in a subordinate position, it will bear losses ahead of the senior mortgage lender. Mezzanine products are proliferating for a variety of reasons, however. This includes a limited availability of traditional credit at higher
loan-to-value (LTV) ratios; stringent credit standards and conservative valuations
ascribed by traditional, senior balance-sheet lenders; and institutional-lender
limitations, including liquidity concerns and risk-based capital restrictions.
Many mezzanine loan products are considered unsecured because there
is no lien on the borrower’s assets, although these loans are typically secured
by an equity partner’s ownership in an asset. They are often short-term
loans and are generally co-terminus with the senior mortgage, meaning
they mature at the same time.
Again, mezzanine debt creates a financial position that appeals to certain
investors. Those who do not have a strong opinion regarding the timing of
economic cycles may receive a higher risk-adjusted return that compares
favorably to senior debt and equity returns. The lender has a valuable
“equity” cushion by not being in a first-loss position. Mezzanine investors
seek equity-like exposure to returns, but desire some risk protection. This is
achieved by having a priority claim over equity, and through higher yields
than senior debt and equity.
Borrowers generally find mezzanine debt attractive because it has the
potential to enhance equity returns and is less restrictive than senior debt. In
addition, mezzanine debt reduces the equity requirements for a deal, and
it has a lower cost of capital than an equity investment.
Borrowers often prefer mezzanine debt to investments from joint-venture
equity partners, because the former allows them to retain full control — and
the full potential appreciation — of the underlying property. The use of mezza-
nine debt also allows a borrower to target larger transactions and be more com-
petitive in terms of pricing, because the average weighted cost of capital is lower.
During the mid-2000s, competition in the mezzanine-financing industry
increased significantly. Real estate and finance companies looking to expand
their investment-management business focused on the real estate debt market
and began originating mezzanine loans. Traditional institutional lenders,
including banks and insurance companies, expanded their business-lending
lines to include mezzanine loans.
Lenders with commercial mortgage-backed securities platforms also began
originating higher-leverage whole loans in which the senior component
was securitized, and subordinate B note (or mezzanine) positions were held
on balance sheets, with the intent to sell at par or higher. There also was a prolif-
eration of new ventures created solely to focus on mezzanine financing and to
capitalize on investment opportunities. After the financial crisis hit in 2008, which
caused asset values to decline significantly, many of the new mezzanine lenders
ceased to exist, and many large institutional lenders exited the business.
Today’s mezzanine market is dominated by hedge and debt funds, mort-
gage real estate investment trusts (mREITs), life insurance companies and
private sources. Each group has very specific parameters and criteria for
originating mezzanine loans, so competition is more limited and varies by
the profile of an individual investment.
Mezzanine loans may be sourced through senior lenders, commercial
mortgage brokers, directly through borrowers and from mezzanine specialty
lenders who are looking for a participant on a large transaction. Unlike
senior loans, which are typically originated through broad marketing efforts,
mezzanine-loan opportunities are often marketed in a limited fashion to a
handful of mezzanine-debt lenders. Therefore, a mezzanine lender’s success
in sourcing transactions is often driven not only by pricing, but also by
strength of relationships, certainty of execution and an ability to provide
creative transaction structures.
Underwriting and pricing for mezzanine debt has changed since the
financial crisis. The assumptions used in cash-flow projections are more con-
servative, with market rent projections generally not exceeding inflation
rates. Debt yields — net operating income (NOI) divided by total debt — for
mezzanine loans generally have an average annual return rate between
6 percent and 8 percent.
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Doug Lyons is a managing principal of Pearlmark Real Estate and is responsible for the company’s capital-
markets and debt-investment activities. He formerly served as vice president of Equity Institutional
Investors Inc. Reach Lyons at firstname.lastname@example.org.
Randall Zisler is chairman of Zisler Capital Associates, which raises capital for property developers and
owners, and provides research, consulting and expert-witness services. He was formerly head of real estate
research at Goldman Sachs and Nomura Securities. Reach Zisler at email@example.com.