Mezzanine capital can help private money lenders win new business.

Mezzanine capital, aka “Mezz,” is essentially preferred equity or second mortgage debt that is needed to bridge the gap in the capital stack between first mortgage debt and sponsor (developer) equity. Mezzanine financing is most commonly used by developers in the commercial and new construction residential real estate development marketplace. They use it to secure supplementary financing for development projects—whose funding requires a substantial equity contribution (e.g., greater than 25 percent of the project cost).

Investors who use mezzanine financing may be able to procure developments without using much or any of their own funds, because mezzanine capital may fund up to 100 percent of the total project cost as a blended cocktail with the first mortgage. It is generally known as an institutional debt instrument recognized as “third-party equity.” That’s because it is often collateralized by the property owner pledging equity in the entity to a third-party investor. In other words, the instrument holder, an investor, will receive a portion of the profits from the gain on sale when the asset is sold. The investor may also receive a portion of the rental income if the asset is held.

It can also be collateralized by a second mortgage and receive an interest rate, although some first mortgage lenders do not allow any subordinate liens on the property for a variety of reasons. Placing one can trigger an immediate technical default by the borrower. A tri-party intercreditor agreement is usually required to overcome the first mortgagee’s objections.

The interest rate, or shared appreciation percentage, that mezzanine capital commands ranges widely within the industry. For larger projects, where the mezzanine portion is in the millions of dollars, a preferred interest rate between 8-18 percent is common. It can be more, depending on the leverage and risk. For smaller projects, mezzanine capital is much less institutionalized, meaning that specialist mezzanine financiers operating in this space have a wider scope of what is deemed equitable; therefore, the interest rate and/or shared appreciation (profit split) can be negotiated with the sponsoring developer. Another interesting point relating to the instrument having debt-like characteristics is that often the interest rate on the note is in line with federal minimums—the Applicable Federal Rate—which is deferred until maturity/exit and deducted from the monies owed according to the shared appreciation agreement. One of the most important reasons to include debt-like characteristics is to make the note saleable on the secondary market.

Boutique investment firms that are focused on the deployment of preferred equity and mezzanine capital look for opportunities to provide liquidity to developers and investors who need to fill the “financing gap” in residential real estate development projects, including existing property improvements (fix and flip rehab projects) and new ground-up construction. Preferred equity and mezzanine products can greatly complement private money lenders’ first mortgage loan programs by allowing both the developers and the lenders to affect more projects—permitting developers to spread their own funds across more projects, and thus achieve higher overall profits.

Expanding Distribution Channels

As stated, providing preferred equity or mezzanine capital to a development on a one-off basis benefits both the developer and the private money lender by enabling existing deals to close that otherwise have a shortage of capital. An even more strategic objective is to enable experienced builders and developers to expand their business by taking on additional portfolio projects, when they have the necessary construction infrastructure and excess deal flow to do so, but are cash constrained. The goal is to take fix and flip developers completing five projects a year to 10, and those completing 20 projects a year to 50.

A survey of private money lenders across the country with volumes of $5-20 million per month indicated that if they were able to offer a preferred equity or mezzanine capital product up to 100 percent of the equity stack (100 percent combined LTC/LTV) for their most preferred Developer clients, they would be able to increase their monthly volume by an additional 38 percent. They noted that if they had an equal or better first mortgage product as their competitors, they would experience an increase in loan volume based solely on marketing the product to mid-volume professional developers, with a view of pre-qualifying them for the approved future projects list. Saving a developer considerable time and angst searching for equity capital from friends, family and other limited partners is a great service. It can reduce developer headaches by allowing developers to work with one sophisticated institutional partner. And in many instances, it can allow developers to retain more of the profit than bringing in an alternative third party that is a less sophisticated investor.

Depending on the preference of the first mortgagee private money lender, a mezzanine financing product can be cleared to fund (via table-funding arrangement) according to a program matrix and seller’s guide. Or, it can be kept separate and funded directly by a specialist mezzanine financier working in unison with the primary lender.

Innovative Bridge Financing Programs

Some investors will also provide preferred equity in the form of true bridge financing to projects where there is a short-term shortage of capital—whether the gap is in the initial stages of opening escrow for the earnest money deposit or due diligence “soft cost” requirements—or to projects involving timing delays with construction drawdowns, construction overruns, consultant costs and other time-sensitive special circumstances. Innovative programs around circumstances like these fill a critical gap in the developer and investor lending marketplace.

Bridge financing solutions offer quick-and-easy financing for real estate investors and developers who need immediate capital for a variety of unforeseen circumstances that require creative, decisive and rapid execution. Essentially, they are a short-term project financing solution, pending the arrangement and approval of alternative funding that will see the project through to completion. The capital advanced by bridge financiers is senior to the developer’s own capital, but junior to any existing first- and second-lien mortgages.

A unique blend of value-added developer- and investor-centric products can help private money lenders differentiate themselves from their competition and win new business they could not have otherwise acquired.