Mezzanine Loans – More Costly Than Mortgages but Much Cheaper Than Equity

Here we will discuss structured finance and the pricing of mezzanine loans.  There are two main types of mezzanine loans – those placed on standing property and those placed on construction projects.  To distinguish he usage we shall use the terms standing mezz and construction mezz.  Commercial lenders will be comfortable with this terminology

Just suppose that an investor bought an office building 8 years ago for $10 million.  Today, the building is worth $18 million.  The investor originally got a $7.5 Million permanent loan from a CMBS (Commercial Mortgage Backed Security) lender that is paid down to $7 million.  Ergo, the investor now owes just $7 million on an $18 million property.  He has decided that he wants to buy another building.  He needs to pull some cash out of his existing mortgage to make the new purchase.

Commercial Lenders (CMBS) don’t permit second mortgages.  Also, their prepayment penalties are high.  Therefore, our investor will have to pull out his equity by obtaining a mezzanine loan from a commercial lender that handles this type of loan.  Currently, mezzanine commercial lenders are very aggressive and the investor shouldn’t have any trouble getting financing with a standing mezz loan at 80% LTV or $7.4 million.

What will this type of loan cost our investor with a reputable commercial lender?  Well, he has two options.  His first option would be to get a floating rate, standing mezz loan.  His second option would be to get a fixed rate loan.

If he went the route of the floating rate with a commercial lender, such a deal would probably cost him one-month LIBOR plus 400 to 500 basis points (bps).  In structured finance, one-month Libor is so common that lenders don’t even have to make reference to the name of the index.  Today one-month LIBOR is around 4.4% so the cost of his loan would be 8.4% to 9.4%.  The investor would be obliged to pay a typical fee of one point, plus an exit fee of one point.

The term of the standing mezz would be coterminous with the first mortgage; i.e., they would mature on the same date.  Since the original commercial lender (CMBS) loan had a term of ten years, and since the commercial lender (CMBS) loan was originated eight years ago, the standing mezz loan would have a term of only two years.

A typical standing mezz loan would have a term of one to three years, but in many cases extension options are available, and some mezzanine commercial lenders are even willing to go as far out as five to ten years.

In this first example of a standing mezz the total “debt stack” of the office building was 80% loan-to-value.  The “debt stack” includes all of the mortgages, mezzanine commercial lender loans, and preferred equity investments directly or indirectly secured by the property.  This shows how the pie is sliced every which way and this is not uncommon in structured financing.  With the right commercial lenders you can usually get the deal done.

Now let’s see if we can find some more commercial lenders to handle a similar deal with a new buyer.  If our new buyer wanted to buy an office building and assume the $7 million first mortgage loan, he might want to find a commercial lender that would do a mezzanine loan up to 90% of the purchase price with him.  Using this scenario our new investor would only have to come up with 10% to put down on the office building.

Of course, the new mezzanine commercial lender loan with a 90% LTV is more risky than one that is at 80% LTV. Mezzanine commercial lenders will usually use the term loan-to-cost here because appraisals are mistrusted and the building is actually costing the buyer $18 million.  A mezzanine commercial lender loan of 90% LTC might cost 500 t0 700 basis points (bps) over.  In this particular scenario the cost to our new buyer would be 9.4% to 11.4%.

Fixed rate standing mezz deals from commercial lenders are typically priced at 450 – 550 basis points over ten-year Treasuries.  Say Ten year Treasuries are around 4.5%, so fixed rate mezzanine loans up to 85% LTV from commercial lenders might cost the borrower 9% - 10% interest.  If our new buyer needed 90% LTC, a fixed rate mezzanine loan might cost 550 – 750 bips over 10 year Treasuries, or 10% to 12% interest.

A construction mezz is usually priced on a floating rate basis with some sort of participation of profit in the deal.  In this type of situation the developer almost always needs at least 90% LTC financing.  A typical financing deal might be priced at 600 – 700 bips over with a10%-25% participation.  Say the one month LIBOR is 4.4%, the interest rate might be around 10.4% to 11.4% plus participation in profits.

There are times when mezzanine commercial lenders may even go up to 93% to 95% of cost.  The downside is that theses loans are so risky that they are almost joint ventures.  And this means they are very, very costly.  Our developer would pay at least 11% - 13% plus up to 50% of the profits.

Equity investments from partners and merchant bankers usually cost in the range of 18% to 30% annually.  Therefore mezzanine financing debt from commercial lenders is much cheaper than equity.