Mezzanine loans get their name from being a hybrid of debt and equity, or essentially an investment that bridges the difference between the two. It’s the highest risk type of debt but can offer returns of up to 20-30%
In the hierarchy of debt and repayment in case of borrower default, mezzanine loans are pretty much at the bottom. Unlike secured debt that’s in a strong position of being covered by the sale of an underlying asset, mezzanine loans are in a junior position and have no claim to the underlying property. In fact, they’re senior only to shares of preferred or common equity.
For companies financing projects costing millions, such as shopping malls, hotels, and industrial parks, typical mortgage lenders limit their loans to 60% or less of the property’s value. Rather than coming up with cash for the remainder, businesses with a history of profitability and viable expansion plans often get additional financing through mezzanine loans. While mezzanine loans aren’t backed by assets, they are secured by stock of the borrowing company. The lender has a warrant to convert the loan into stock in case of default, and thus have control over the borrower company, and ultimately all of the assets it owns.
Let’s work through an example of how a mezzanine loan alternative investment would work for an investor.
Bottom Line
There is no denying that mezzanine loans carry a high level of risk, something that’s important to consider before adding such an investment to your portfolio. However, the risk inherent in such loans (since there is no asset as collateral that the lender can sell to recoup their investment) dictates the high-interest rates that borrowers pay. The hybrid debt/equity nature of a mezzanine loan can produce equity-like returns with debt-like consistent interest payments. If the financed project collapses into default, the mezzanine lender can convert their loan into the borrower parent company’s equity, and control all of the underlying assets. However, there is no guarantee that after satisfying the more senior debt (debt backed by assets), the full loan can be recouped. A failed project can harm the standing of a parent company, and the value of other assets, leading to a significant loss on the loan. Still, there are no rewards that come without risk when it comes to investments, and mezzanine loans can be a worthwhile strategic addition to your portfolio.
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