Developers will often rely on different kinds of financing to round out a capital stack and get a complex project off the ground. Mezzanine financing in real estate development bridges the gap between senior debt and equity investment. In other words, mezzanine financing provides additional funding to cover the shortfall between what the traditional lender (a bank or institutional lender) is willing to lend and the total capital required for project funding. The structure offers an option that is riskier than senior debt but less risky than equity, allowing developers to secure funding while preserving ownership stakes.
Here you’ll learn the ins and outs of mezzanine financing, including the benefits, risks, and strategies you need to leverage it effectively:
What is Mezzanine Financing in Real Estate?
Mezzanine financing is a hybrid of debt and financing that gives the lender the right to convert the debt to an equity interest in the company in the case of a default, generally after venture capital companies or other senior lenders are paid. In the capital stack, mezzanine financing sits between senior debt and its common stock as subordinated debt or equity. The most common structure for mezzanine financing is unsecured subordinated debt. It is sometimes considered very expensive debt or cheaper equity because it carries a higher interest rate than the senior debt companies would otherwise
Lenders for mezzanine financing, which commonly include real estate funds, insurance companies, or individuals, will typically have the right to take possession of the borrower’s equity in a property if the borrower defaults. However, in the case of default, the lenders won’t take the asset itself. Mezzanine lenders are seen as above equity investors in terms of payment but below mortgage or traditional lenders. In general, risk on mezzanine financing is also considered a middle of the capital stack, meaning lenders take on more risk than with senior debt but less risk than equity investors.
Senior Debt: (from banks or institutional lenders) is the primary loan but usually covers only 50–70% of a project’s total cost.
Equity investment: (from developers, investors, or sponsors) covers a portion of the remaining cost, but developers often seek to minimize their cash contribution.
How Mezzanine Financing Works
Loan structure
As the name suggests, mezzanine debt falls in the middle of the capital stack between senior debt and subordinated debt or preferred equity. The most common structure for mezzanine financing is unsecured subordinated debt. Unsecured subordinated debt is ranked below senior loans or debt in its claim against the company’s earnings. Lenders, who are the subordinated debt holders, won’t be paid out until senior debt holders are paid out in full. Mezzanine debt can be secured by a placing a lien against the owner of the property. In simple terms, mezzanine financing is secured by a pledge of equity instead of the property itself.
Interest Rates
Interest rates on mezzanine debt tend to be higher due to the lack of collateral and usually fall between 9 and 20%. The rates will vary depending on project risk and market conditions, borrower’s financial track records, and return structure. Since interest rates are structured as fixed-rate debt, interest-only loans, or a debt with an equity component, the cost can vary dramatically depending on the terms negotiated between lenders and borrowers.
Repayment Terms
Mezzanine financing tends to mature in five years or more, and with interest only payments the principal remains unpaid until maturity to reduce the financial burden for developers during the construction and stabilization phases of a project’s lifecycle. If a developer is using a balloon payment structure, no or minimal payments may be required in the loan’s term. Developers typically pay off balloon payments by securing long-term financing in the form of a permanent mortgage or selling the property. Mezzanine lenders can also negotiate for a portion of repayment to be in the form of conversion to equity, which looks like a percentage of ownership or profit sharing upon sale or refinancing.
Benefits for Real Estate Developers
Leveraging mezzanine financing can have many advantages for developers, Here are some of the top advantages you can expect from it:
- Capital Efficiency – Developers can decrease their equity contribution by leveraging mezzanine financing, freeing up funds to be contributed to the project elsewhere, and either to other aspects of the project or elsewhere in your portfolio. Mezzanine financing also reduces the amount of equity required in an overall real estate deal, meaning a higher return on equity (ROE) for investors.
- Flexible Structure – Mezzanine loans typically come with higher interest rates, but terms are often shorter and repayment plans are flexible. In many cases, you can repay the loan at the end of the term, allowing you to ensure the project is stabilized and generating returns before repayment.
- Speed & Accessibility – By taking advantage of mezzanine financing, you can bridge your financing gaps without having to increase your contribution or raise additional equity funding. Investors also may not require collateral on a mezzanine loan, meaning it doesn’t need to be secured and is lower risk for the borrower.
Potential Risks and Challenges
Mezzanine financing can play a key role in financing a project, but it’s not without several key risks or challenges. Since it isn’t secured, interest rates tend to be higher than senior debt and loans may have more covenants included. Senior lenders may also impose restrictions in the form of intercreditor agreements, which will outline the lender’s rights to receive payments from the borrower and to enforce security interests in the borrower’s collateral. Mezzanine loans also carry unique risk in the case of a default for this reason, and a project’s equity can be lost if payments are missed.
When Should Developers Consider Mezzanine Financing?
There are several key scenarios where developers should consider mezzanine financing. Gap funding is the additional capital developers need when there’s a shortfall between funds available (senior debt and equity) and the total cost of the project. Funding gaps can occur for many reasons, including Loan-to-Cost (LTV) or Loan-to-Value Limits set by traditional lenders, unexpected costs in the development process such as high construction material costs, or working capital shortages that are blocking the developer from completing or stabilizing a project. If there’s a need for gap funding, developers should consider mezzanine financing.
Mezzanine financing can be used on a variety of commercial real estate development projects, including expansions, adaptive reuse, and acquisitions. Developers can use it to maximize leverage and minimize equity dilution when additional funding is needed. Instead of raising more equity, which decreases ownership share, developers can use mezzanine financing to increase leverage while keeping a higher stake in the project. To be successful, developers should pursue mezzanine loans on projects where high returns are expected.
How to Secure Mezzanine Financing Successfully
Since mezzanine financing is a higher risk form of debt for lenders, it typically comes with stricter criteria for lending than other types of financing. Developers will need to demonstrate a track record of project success, strong project fundamentals, and a clear repayment strategy to lenders. Below are some key steps your team can take to guarantee your financing is secured successfully:
Show Strong Track Record
Demonstrating an ability to deliver projects on time and on budget bolsters your reputation with lenders. Lenders want to see your ability to execute projects of a similar size and scale, as well as a history of debt repayment. Modern real estate development software can help your team compile and present historical data from past projects. Northspyre’s Funding Portal gives your capital partners visibility on the financial information they care about, helping you build trust and credibility. Investors will also be able to track spending through each funding period, allowing them to have confidence in how their funds are managed.
Optimize Your Capital Stack
Lenders want to see the project’s loan-to-value (LTV) and loan-to-cost (LTC) ratios to determine risk before offering a mezzanine loan. You can improve your financing terms by keeping your senior debt manageable (between 50-70% LTV) and offering a reasonable developer equity contribution (about 10-20%). You want to be able to show how mezzanine financing fills the funding gap without overleveraging, which will allow you to negotiate favorable loan terms.
Build Relationships with Mezzanine Lenders
Building relationships with mezzanine lenders can help you secure mezzanine funding for your CRE development project. Private equity firms, hedge funds, offices, and institutional debt funds are common providers of mezzanine funds. Be sure to identify which lenders specialize in your proposed asset class – i.e. multifamily, office, retail, mixed-use. Keeping open and transparent communication with lenders and allowing financers to be in the loop about potential upcoming opportunities in addition to current projects can help you foster a long-term relationship.
Mezzanine financing can be key in getting a complex real estate development project off the ground. Developers can use mezzanine loans in the capital stack to round out funding without diluting equity stake. Building strong relationships with mezzanine lenders and being aware of the potential pitfalls will ensure your project is successfully financed, achieves stabilization, and begins generating high returns.
Northspyre can play a key role in your financial planning with robust investor lending and reporting capability. The platform enables automated draw reports, compliance checks, and approval workflows. Draw and approvals capability ensures your team can review and approve draw packages before sending them to mezzanine financing partners. The ability to generate instant and reliable PDF reports documents who approved which invoice and makes it easy to track financial decisions.
Book a demo to learn more about how Northspyre can help your development team successfully manage budgets on complex projects.
