In many cases, merchant builders looking to maximize their IRR also need to maximize leverage, as the cost of equity is often more expensive than non-recourse debt. In other situations, merchant builders simply need more leverage to keep liquidity available for other opportunities. When looking to build your capital stack, your first option should be mezzanine financing and preferred equity.

While multifamily and commercial mezzanine lenders often prefer to have a recorded second mortgage as security, a pledge of stock is also an option for securing your mezzanine financing; this is commonly referred to as preferred equity. Although there usually isn't any true equity or waterfall requirement, the security itself is considered equity. Therefore, collateral is the typically only true difference between mezzanine loans and preferred equity.

How Mezzanine Financing Works in Practice

Let’s say that you wanted to purchase a $10 million multifamily property that produced $1 million in rental income. A bank is willing to give you a $7 million, 70% LTV loan on the property with a 6% interest rate and a 25-year amortization, which means you would contribute $3 million equity into the property. This also means that you’ll be paying a mortgage of approximately $45,100/month, or about $541,000/year.

In this situation, you would receive a pretax income of $459,000. Assuming you pay an income tax of 35% (and received an after tax income of about ($298,000) and you sold the property for $11 million at the end of a 5 year period, you would have achieved an IRR of 17.89%.

Example 1: Return on a $10 Million Property With 70% Senior Debt Only

 
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Now, let’s say that instead of just taking on 70% LTV loan from a bank, you also decide to take out an additional, 5-year, interest-only $1.5 million mezzanine loan with a 12% interest rate. In this situation, you would be paying both your $541,000/year mortgage payment to the bank, and a $180,000 payment to the mezzanine lender for a total annual debt service of $721,000. If we continue the assumption of a 35% tax rate, this would reduce your annual income to $180,000.

However, you would only need to put $1.5 million in equity into the property. So, if you sold this property at the end of the 5-year period for the same price ($11 million), and paid off both of your lenders, you would have effectively increased your IRR to 25.67%. So, while you may have reduced your cash flow from this specific investment, you have an additional $1.5 million that could be invested in other properties, or other types of investments entirely.

For the purposes of these examples, we are not including taxes on the profit from the sale or commercial brokerage fees, but despite this, it’s safe to say that increasing leverage with mezzanine debt is a time-tested method for increasing returns from a commercial real estate investment.

Example 2: Return on a $10 Million Property With 70% Senior Debt and a 15% Mezzanine Loan

 
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Other Considerations for Mezzanine Debt

While mezzanine debt greatly increases leverage, some senior lenders don’t allow it. For instance, HUD multifamily loans never permit mezzanine loans, while agency lenders like Fannie Mae and Freddie Mac typically restrict mezzanine debt to approved sources lending under specified guidelines. CMBS lenders often permit mezzanine debt, but not always. When a senior lender does agree to permit mezzanine debt, both lenders must sign an intercreditor agreement, which governs the rules between the two parties in regards to how and when each will get paid.

In some real estate deals, especially ones in which a borrower’s financials aren’t as strong, a lender may incorporate an equity kicker in exchange for reduced interest rates. An equity kicker provides the lender a small piece of equity in the property, which can be extremely lucrative if the real estate market takes off and the property is sold for a large profit.

In some cases, borrowers can avoid paying part of their interest until they actually repay their loan, by actually increasing the principal of the loan itself. This is known as payment-in-kind interest, or a PIK toggle. For example, a borrower with a 12% interest rate could pay 10% of their interest up front and 2% on the back end. This interest, however, is added to the principal and, while it will free up cash flow in the short run, it will increase the overall interest paid throughout the life of the loan. PIK interest is not used often in for real estate mezzanine loans, and is more often used in corporate finance, though it is still utilized upon occasion.



Sample Mezzanine Financing Loan Terms For Multifamily and Commercial Property Loans as of April 2019

Amount:                     $3 million and up

Term:                          Coterminous with first (typically between 5-7 years)

Interest Rates:          Typically between 9% - 16% (interest only)

Fees:                          3% - 6%

Maximum LTC:          85% 

Pros:

  • Increases leverage and IRR

  • Interest is tax-deductible

  • Flexible options include equity kickers for reduced interest rates and PIK toggles for reduced interest payments

Cons:

  • Can be extremely expensive (up to 20% for some borrowers)

  • Not allowed by all lenders

  • High fees and additional legal costs