As that table shows, the investor would reduce their equity financing requirement while boosting their return on investment by taking out the mezzanine loan.
The benefits of mezzanine financing
Mezzanine financing has two main benefits to the borrower:
1. It reduces the amount of equity needed to fund an acquisition or expansion project.
2. It increases the return on their equity investment.
The reduction in the equity requirement has some important advantages. For example, an investor can use that equity for another deal, which would further leverage their returns. Meanwhile, it also aids those who don't have enough capital to satisfy the need since they won't have to bring on other equity financing partners and dilute their ownership interest.
A mezzanine investment, likewise, has several benefits to the lender, including:
- The ability to earn a higher interest rate on the loan they provide to a borrower.
- Lower risk of loss, as these loans have a higher priority than both common and preferred equity in the event of a bankruptcy.
As such, mezzanine debt can offer the lender an equity-like return with a bond-like risk profile. While it's not as low risk as secured debt, nor is the return upside as much as equity, mezzanine lending can offer attractive risk-adjusted returns.
How to determine whether mezzanine financing is the right choice
An investor needs to weigh the pros and cons of utilizing mezzanine financing to decide whether it's their best option. While it reduces the amount of equity they need to put up in a transaction and can boost their returns on that investment, it also increases their risk. It raises the leverage level of the property, which cuts both ways as it increases profits when the investment pays off but results in bigger losses if something goes wrong. Further, with less equity to cushion the blow of losses, real estate investors risk a complete loss of capital they put into a deal.
Mezzanine financing helps bridge the funding gap in real estate
A mezzanine loan is an important funding tool for real estate investors. It can help cover the difference between the equity they have to put into a transaction and the senior debt financing available from lenders. While these loans increase a deal's risk profile, they also enhance the return potential.