Many acquisition and development projects require additional financing beyond a traditional first mortgage. The simplest, fastest and least expensive method of borrowing in these situations is to have the seller or another lender write a traditional 2nd mortgage. Unfortunately, especially in today's era of tightened credit, 2nd position liens are often impossible, due to an equity shortage, or disallowed by mortgage covenants mandated by the 1st position holder. The-fact-is that there are many scenarios where the option of a simple 2nd is just not available. These scenarios give rise to what's known as mezzanine lending.
Unlike a mortgage, a mezzanine loan is not a lien against a piece of commercial real estate. It is a loan secured by the assets of a business entity. A title search will not turn up mezzanine loans because they are not attached to a properties ownership documents. In this way they do not violate any provisions of a 1st mortgage that precludes a 2nd.
With the cooperation of the borrower, a mezzanine lender sets up a single purpose, business entity, such as an LLC or a Trust. Title and ownership of the target real estate and corresponding businesses are placed in the entity so the whole project is owned by the new company. The company is run by the borrower. The actual mezzanine loan is made to the company but is also personally guaranteed by the principle borrowers. The loan is secured by the assets of the company (the real estate and its operations) and allows the lender to take over full ownership and operations in the event of default.
Although simple in concept, mezzanine lending is complex and difficult in practice. Attorneys for both the borrower and the lender must be very involved in drafting the provisions of the loan and making sure the new entity is properly set up and maintained. Borrowers want their rights protected while lenders need to make sure their security interest in the firm and, indirectly, the real estate is legally binding. Often the real estate, the borrower and the lender are domiciled in different States making the whole enterprise subject to interstate commerce regulations and further complicating the loan.
The legal and closing costs as-well-as maintenance costs associated with mezzanine loans are extremely high compared to conventional lending. For this reason mezzanine financing structures are wholly inappropriate for small deals. It's very difficult to make mezzanine capital cost effective in projects worth under $10MM.
Mezzanine loans certainly have their place; their loan volume can be counted in the tens of billions of dollars. When they're needed and when done correctly they are true deal savers. A partnership with a mezzanine lender can be an invaluable resource to a developer or commercial real estate investor. However, investors and developers need to understand exactly what a mezzanine loan is and be ready for the costs that come with them.