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The commercial real estate market is booming right now, with opportunities for significant growth available to those who can secure financing immediately. Unfortunately, for some would-be investors, many traditional banks are heavily scrutinizing applications for commercial real estate loans and requiring the borrower to put forward more equity.
To take advantage of the growth in this sector, it can be necessary to seek out less traditional funding sources. Mezzanine debt is one such type of financing, one that carries a higher interest rate and must be paid back sooner. However, mezzanine financing is one very practical way to keep more cash on hand while making the most of the growing commercial real estate market.
If you’re wondering, “What is a mezzanine debt?”, read on to learn more about this form of financing for commercial real estate.
For most commercial real estate projects, a borrower will seek out a traditional loan from a bank. These loans are very similar to a home mortgage in that they have relatively low-interest rates and longer repayment terms.
The loan is secured with the real estate as collateral; if the borrower defaults on the loan, the bank can take possession of the property and sell it to recoup their losses. Banks expect borrowers to cover 20-30% of the purchase cost of the property to ensure there’s enough value in the property to cover their loan if there is a default.
Many business owners prefer not to use their own money to cover 20-30% of the property’s purchase price, as this could leave them low on cash for operating expenses or other real estate ventures. This is where mezzanine debt comes in. What is mezzanine debt?
It’s structured so that a borrower can take out a loan with a mezzanine lender, who will then cover some of the equity the borrower would have provided. The mezzanine lender does not use the property as collateral though, making it a much riskier loan. As such, the interest rates are much higher, often two to three times as much as a traditional bank loan.
Additionally, mezzanine lenders are given a lower priority than senior debt holders like traditional banks. In the event of a default, where assets are liquidated, the mezzanine lender is paid back only when the senior debt holder (the bank) is completely paid back.
Suppose you wanted to purchase a commercial real estate property that’s valued at $1,000,000. You could secure financing from a traditional bank, which provides you with $750,000. The bank might offer that loan with an interest rate of 8% per year. To purchase the property, you’d need to put up $250,000 of your money.
Now assume the property can earn you around $200,000/year, with $60,000 of that going back to the bank for interest payments. This leaves you with a profit of $140,000, which after taxes might be closer to $90,000 –– a return of 36% on your $250,000 investment.
To lower the amount of equity you put into the property, you could find a mezzanine investor to put in an extra $150,000 at 18% per year, leaving you with $100,000 in equity. The bank would get the same $60,000 in interest payments, but your mezzanine investor would get $27,000, making your after-tax profit $63,000. However, that’s $63,000 from an investment of only $100,000 –– a return of 63%! This is the power of leveraged debt.
Another option for financing a commercial real estate venture is preferred equity. Instead of providing a loan, a lender receives a stake in the property in exchange for financing a portion of the purchase price. Typically this involves the lender receiving a dividend from the property, which may be fixed, rather than tied to its cash flows. Should the owner of the property default on these payments, the lender can remove the owner from managing the property so as to recoup their contributions.
While preferred equity financing doesn’t involve paying interest on a loan, there’s the possibility that you could lose control of your investment. To ensure control over your investment, mezzanine debt can be a more attractive option. Even though it comes with a higher interest rate, the leverage you gain from it more than covers its cost if the property proves to be profitable.
Mezzanine debt can be an attractive option for some commercial real estate projects, but it won’t always be the best option. Fortunately, AVANA Capital can help to bridge your funding gap with its commercial construction loans.
AVANA Capital has been serving business owners and entrepreneurs for over 20 years. With over 150 years of combined experience, the team at AVANA Capital offers a diverse range of funding options, from SBA 504 loans to bridge loans to construction loans for commercial real estate. AVANA Capital can help you get your commercial real estate project off the ground, with interest-only payment plans for the first two years.
Our financing is fast and simple to ensure you can start your venture as soon as possible. Don’t wait –– contact us today to find out how we can make your commercial real estate dreams a reality.