Alexis Assadi: Understanding Mezzanine Financing
Alexis Assadi finances real estate projects in his personal capacity and also serves as the CEO of Pacific Income Capital Corporation, along with various other businesses. In this article, he explores a common debt product, called mezzanine loans.
Mezzanine financing is a short-term loan, typically with maturity dates of between three months to three years. It is intended to serve as a “mezzanine” or a “bridge” between a significant business event, such as a refinance or a sale. It is also known as a bridge loan.
Who Uses Mezzanine Loans?
Mezzanine loans can be taken by any borrower. But they are particularly common among real estate developers. Consider this example:
Annette purchased a four-unit townhouse that was occupied by three tenants. She put down 25% and received the rest of the funding in the form of a mortgage from a large bank. Since the property wasn’t fully occupied, the bank considered it a high-risk deal. It therefore charged an annual interest rate of 9%.
Before Annette brings in a fourth renter, she wants to undertake significant renovations. Here’s why:
- She thinks that spending $20,000 on upgrades would boost the value of the entire real estate by $40,000.
- She thinks could charge an extra $300 a month for rent.
- With the foregoing in place, she believes that she could get a new mortgage at only 5% per year.
Annette seeks a private lending company, like Pacific Income Limited Partnership, that might consider her business plan. She finds a firm that’s willing to lend her $40,000 for five months, which is how long the renovations are expected to take.
The company charges a:
- 2% origination fee
- 14% annualized interest rate
The loan is secured with a second mortgage over the townhouse complex.
In all, the loan will cost Annette over $6,000. But, in her view, the benefits of increasing the property value, charging additional rent and securing a cheaper long-term loan outweigh the expense.
Why was the Bridge Loan So Expensive?
Discussion of risk aside, short-term lenders don’t have a lot of time to profit from interest payments. While a bank can get paid for the next three decades, a mezzanine loan might only bear interest for a few months. Therefore, their loans can be costlier.
The Risk Profile for Mezzanine Lenders
Part of the risk for bridge lenders is the borrower’s ability to repay the debt within the allotted time. In Annette’s case, for instance, there are several variables. They include:
- Will she be able to complete the renovations on time?
- Will the renovations cost more than budgeted?
- Will they induce a bank to lend at a lower rate?
Of course, all of this is in addition to the general risks of mortgage lending.
As such, it’s important to know whether the borrower has a reasonable plan for repayment. Further, if the loan extends beyond the maturity date, what does the lender plan to do about it?
The Benefit for Bridge Lenders
If all goes to plan, the lender for Annette will have earned a good rate of return in a short period of time. Moreover, the loan was collateralized with real estate.