What are the pros and cons of using mezzanine debt in your multifamily development capital stack?

1 What is mezzanine debt?

Mezzanine debt is a hybrid form of financing that combines debt and equity features. It is typically secured by a pledge of the borrower's ownership interest in the property, rather than a direct lien on the asset. This means that mezzanine lenders have a secondary claim on the property, after the senior lender, in case of default or foreclosure. Mezzanine debt usually carries a higher interest rate than senior debt, but lower than equity. It also often includes an equity kicker, such as warrants or options, that gives the mezzanine lender a share of the upside potential of the project.

2 Why use mezzanine debt?

Mezzanine debt can offer several advantages to multifamily developers, such as increasing leverage, enhancing flexibility, and providing an alternative source of capital. By allowing developers to reduce their equity contribution and increase their return on equity, mezzanine debt can fill the gap between the senior debt and the equity required for the project. Moreover, mezzanine debt can have more flexible terms and covenants than senior debt, giving developers more room to negotiate and adjust to changing market conditions. Additionally, mezzanine debt can be beneficial for developers who may have difficulty raising equity or senior debt from traditional lenders or investors.

3 What are the risks of mezzanine debt?

Mezzanine debt presents multifamily developers with several risks and challenges, such as higher costs, higher risks, and higher complexity. For example, mezzanine debt is more expensive than senior debt in terms of interest rate and fees, which can increase the overall cost of capital for the project and affect its feasibility and profitability. Furthermore, developers have to service both the senior and mezzanine debt and might lose their equity stake if they default on either one. Additionally, mezzanine lenders have more power and rights than equity investors, potentially taking over the project or forcing a sale if the project underperforms or violates the loan agreement. Lastly, mezzanine debt adds complexity to the capital stack as it involves multiple parties, layers, and agreements which must be coordinated and aligned to comply with different terms and conditions.