Updated · Part of the CRE investment glossary
How mezzanine debt works
The senior lender makes a mortgage loan to the company that owns the property. The mezzanine lender lends to that company’s parent and takes a pledge of the parent’s ownership interest in the property owner. That pledge is personal-property collateral under Article 9 of the Uniform Commercial Code (UCC), not real estate.
If the borrower defaults, the mezzanine lender can sell the pledged interests in a UCC sale, which must be commercially reasonable in every aspect under UCC §9-610, and take over ownership of the property company subject to the senior loan. That process is typically much faster than a mortgage foreclosure.
An intercreditor agreement between the two lenders sets who may do what: the senior lender’s consent to the mezzanine loan, the mezzanine lender’s right to cure senior defaults or buy the senior loan, and who may own the property after a mezzanine foreclosure.
Combined leverage and coverage
Lenders and sponsors test a mezzanine loan on the combined numbers, not the senior loan alone:
Combined LTV = (senior loan + mezzanine loan) ÷ property value; Combined DSCR = NOI ÷ (senior + mezzanine debt service)
- NOI: net operating income for the same period as the debt service.
- Debt service: interest, plus principal if the loan amortizes; any PIK (payment-in-kind) interest accrues to the balance instead of being paid.
- The senior lender’s own LTV and DSCR tests ignore the mezzanine loan.
Worked example: adding a mezzanine loan
A property is worth $20,000,000 and earns $1,300,000 of NOI, a 6.5% yield. The sponsor compares a $12,000,000 senior loan at 6.5% interest-only with the same loan plus a $3,000,000 mezzanine loan at 12% interest-only. The rates are assumptions for the example, and closing costs are ignored.
The mezzanine loan cuts the equity needed from $8,000,000 to $5,000,000 but costs 12% against a 6.5% property yield, so the cash yield on equity falls from 6.5% to 3.2%. It pays off only with growth: at a $24,000,000 sale, equity receives $12,000,000 (1.50x) without mezz and $9,000,000 (1.80x) with it. At an $18,000,000 sale, equity receives $6,000,000 (0.75x) without and $3,000,000 (0.60x) with.
| Measure | Senior only | Senior + mezzanine |
|---|---|---|
| Senior loan (6.5%) | $12,000,000 | $12,000,000 |
| Mezzanine loan (12%) | — | $3,000,000 |
| Equity required | $8,000,000 | $5,000,000 |
| Loan-to-value | 60% | 75% |
| Annual debt service | $780,000 | $1,140,000 |
| DSCR | 1.67x | 1.14x |
| Cash flow to equity | $520,000 | $160,000 |
| Cash-on-cash yield | 6.5% | 3.2% |
Mezzanine debt vs preferred equity
The two sit at the same level of the capital stack and can cost similar amounts. The differences are in the documents:
- Legal form: mezzanine is a loan; preferred equity is an ownership interest.
- Collateral: mezzanine takes a pledge of the ownership interests; preferred equity has none and relies on the operating agreement.
- Remedy: a mezzanine lender forecloses on the pledge in a UCC sale; a preferred investor removes the managing member under the operating agreement.
- Senior lender: many senior loans restrict subordinate debt, so mezzanine needs the senior lender’s consent and an intercreditor agreement.
What to watch for
Mezzanine debt adds a second lender with its own rights, so check more than the rate:
- Maturity: the mezzanine loan usually matures with or before the senior loan, so both must be refinanced together.
- PIK interest and exit fees, which raise the payoff above the original balance.
- Combined DSCR thin enough that a small fall in NOI stops cash flow to equity.
- Intercreditor terms on cure rights and who may own the property after a mezzanine foreclosure.
- Personal guarantee or carve-out obligations the sponsor signs for the mezzanine loan.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.