What is a mezzanine facility?

When raising a debt facility, sometimes, different lenders take senior and junior positions in the facility based on their risk/return appetite.

Banks are generally the senior lenders in most facilities, while non-bank lenders looking for higher yields take a junior position in the bank but higher than the equity position in the facility.

What Does a Mezzanine Facility Mean?

Mezzanine describes a layer of financing that bridges senior debt provided by warehouse lenders with the equity capital injected from originators.

It fills a gap between max loan-to-value ratios that conservative senior lenders are willing to underwrite, typically ranging between 70-85% of asset values, and the equity tranche in the warehouse facility.

Some key characteristics of mezzanine facility include:

• Higher Interest Rates – pricing is generally SOFR + 10%
• Lien Position – Subordinated to senior debt
• Limited Recourse Beyond Asset – No personal guarantees, possibly a partial corporate guarantee
• Warrants – Equity to participate in the potential upside

In essence, mezzanine lenders allow originators to leverage their equity position further. Mezzanine lenders come in when the facility has had a track record and want to get compensated for higher risk (by charging higher rates).

Why Do Warehouse Startups Use Mezzanine Loans?

Beyond the obvious benefit of reducing capital needs coming out of pocket, here’s a deeper look at key reasons originators utilize mezzanine financing as part of their funding strategy:

1. Access Enhanced Leverage Levels: While senior construction loans rarely exceed 60% to 65% loan-to-cost ratios, adding mezzanine debt can push leverage amounts to 80% or more of total required capital. This substantially lowers the Equity Check needs upfront.
2. Complement Risk / Return Profile: With equity capital responsible for any losses on a deal, mezzanine shares the upside returns in proportion to their risk position without diluting ownership control or forcing personally guaranteed recourse.
3. Repayment Flexibility: Beyond max senior loan tenors of 5 years or so, mezzanine debt matches mid-term hold periods allowing cash flow ramps to seasonally stabilize so equity is conserved longer for more asset plays.
4. Funding Scalability: For startup sponsors with a pipeline of projects, establishing an umbrella mezzanine facility with a private lender allows for efficient funding against a prequalified master credit line.

What Private Capital Groups Supply Mezzanine Loans?

In commercial real estate, mezzanine capital providers emerge from similar alternative investment firms relative to other industries but even more specialized in asset classes.

• Private Credit Funds
• Mortgage REITs
• Asset-Focused Hedge Funds
• Real Estate Opportunity Funds

Average mezzanine facility sizes range quite widely from $3 million to even $100 million+ for portfolio financings given the breadth of property projects requiring flexible leverage beyond senior lending levels.

What Are Typical Mezzanine Capital Terms?

While each mezzanine financing situation contains unique nuances, average deal structures in commercial real estate tend to norm around:

Interest Rates:

11% – 15%+ fixed or floating benchmarked against short term LIBOR/SOFR indexes

Term Lengths:

5 – 10 year (including initial interest only grace periods)

Amortization Structures:

Sculpted around projected occupancy and rent roll ramps

Loss Recovery:

Primarily interest with smaller principal contingent guarantees

Equity Upside Sharing:

5% – 20% profit participations after senior loan paid

Collateral Rights:

2nd lien deed of trust behind senior mortgage

What Does the Mezzanine Financing Process Entail?

If aligned on strategic rationale and proposed economic terms makes sense for both sponsor and private lender, here are the key milestones to finalize a commercial real estate mezzanine loan:

1. Submit Formal Asset Package for Underwriting: Building off pitched materials, the lender commences detailed due diligence with 3rd party appraisals, environmental studies, tenant risk reviews, cash flow modeling etc.
2. Review Conditional Term Sheet Provisions: An initial term sheet will outline proposed deal structure specifics for negotiation around rates, terms, guarantees, and profit shares as key economic discussion points.
3. Cooperate On Supplementary: Due Diligence Requests
   Before securing final internal approvals, lenders will conduct site visits, management interviews, tenant credit underwriting, and follow-ups on sourced materials.
4. Finalize & Execute Financing Agreements: Attorneys collaborate to navigate complex deal contractual agreements enhancing structural protections where possible beyond just core commercial terms.
5. Funding & Closing Process: With ink dry on approved contracts, closing formalities involving final title reviews lead up to funding escrows & transfers to deposit capital into SPV accounts to be deployed.

Evaluating Mezzanine Capital Fit

With so many real estate orientated private lenders active in mezzanine, performing due diligence assessing compatibility is key before submitting formal applications.

Volume Metrics:

• Average Deal Size Preferences
• Capital Deployment Capacity

Asset Class Preferences:

• Property Type Expertise
• Geographical Focus or Limitations
• Risk Profile Comfort Levels

Deal Structure Flexibility:

• Creative Structuring Thresholds
• Value-Add Tolerance
• Ability to Fund Future Phases

Assembling a Convincing Mezzanine Loan Request

Crafting a polished mezzanine loan request requires tailored positioning aligned to the metrics prioritized among commercial real estate capital providers, balanced with enough creativity displaying intimate sponsor familiarity with unique asset situations.

Key sections to showcase beyond just standard property proformas include:

Sponsor Experience Profile Illustrating track records navigating similar warehouse situations underscores credibility around base case cash flow projections as achievable.

Local Market Familiarity In-depth insights into economic influences, tenant demand drivers, and supply chain contexts reflect embedded perspective lenders take comfort from.

Risk Mitigation Highlights Beyond collateral factors, outline additional guarantee vehicles secured alongside rights to property cash flows providing downside protection.

Asset Repositioning Angle For value-add plays, showcase’ specialized capabilities to enhance property positioning and play into outsized profit pools that mezzanine loans can share in based on flexible structures.

Structuring Flexible Exit Options

Even as project business plans hit stride, evaluating options for recapitalizations or ownership transfers allow sponsors to harvest equity for further plays or liquidity events for partners.

Embedding features like prepayment flexibility, supplemental reserve guarantees, and aligned interim milestones for covenant relief build relationships to fund future pools of assets using proven models.

Optimizing the Capital Structure with Mezzanine Loans

While mezzanine debt may not prove ideal for simpler transitional asset holds, the creative structuring and cash flow alignments offered between senior property loans and sponsor equity make it compelling funding ingredient for value-add warehouse turnarounds.

Properly tapping mezzanine capital allows startup sponsors to scale their bread-and-butter operational value drivers faster across more property assets.

And the relationships formed in these deals via performance build reputations to access special situation financing conduits from leveraged REC funds as portfolio credentials grow.

So rather than just fixating on senior leverage ratios sticker prices, dig into mezzanine structures so outside equity requirements are optimized as startup sponsors looking scale through the critical growth phases in emerging logistics markets.