Mezzanine Debt Modeling

[crelyst]

Hi Lev, I’ve been enjoying your course. I have some questions:

How would you model mezzanine debt? Is this something you would model under your discounted cash flow pro forma? If so, would this go below the amortization (your principal payment) and interest expense? If so, what is the typical LTV and rate % for senior debt? Not too sure how to go about this in general.

For example, let’s say – that a multifamily asset is priced too high, however, an investor doesn’t want to miss out on owning an excellent asset in a great location. So, the investor decides to contact one bidding sponsor to offer mezzanine finance thus becoming a senior equity partner rather than the sole owner of the asset. The advantage to the prospective bidder would be a lower cost of capital and therefore a better return on their equity. But, if the market turns and asset prices were to fall, the investor would end up acquiring the property at a good price. And if there is no downturn, the investor still gets paid a return on its investment.

Thank you in advance for your guidance with this.

 

[Lev]

Modeling Mezzanine Debt

Sounds like you’re asking from the perspective of the equity investor. So first, make sure you read our blog on the capital stack, with focus on seniority. I just want to be clear that mezzanine debt is by no means equity, it is just a subordinate tranche of debt. So when a real estate private equity firm raises mezzanine debt, they are giving up no control of their equity stake. They’re just adding a slice of the capital stack between themselves and the senior debt.

On modeling mezzanine from the REPE perspective, again, it’s just another piece of debt. So you can just show an additional line for the incremental amortization and the incremental interest expense.

LTV

Typical LTV for senior debt goes up to ~50 to ~60%. So, mezzanine debt then fills in anywhere from 60% to 80%. However, a lot of REPE funds’ LP agreements cap fund leverage around ~70%, so you’ll only see mezz filling in that final slice between 50%/60% up until 70%. Anything after that LTV is usually structured as preferred equity, but then you’re really getting aggressive with your financing.

Rates

On rates, this really depends on market conditions. I’d recommend checking Bloomberg / SNL for recent issuance if you have a subscription, or a free alternative if not. Otherwise company filings can be helpful too. If it’s any help, I’ve seen the same core building’s mortgage price ~L+2.30% and its mezz price ~L+5.25%. So you can see some healthy spreads between the two, often more drastic than that.

[Author]

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