Understanding Mezzanine Financing

Thursday, April 1, 2004 - 01:00



The tremendous growth in recent years of capital mortgage backed securities (CMBS) financings for real estate projects, with their low loan-to-value ratios and other tight underwriting criteria, has created a need for a means by which real estate owners can obtain additional financing proceeds.A new approach was especially needed since CMBS lending generally prohibits traditional second mortgage loans on its mortgaged properties.Mezzanine lending has developed to fill this need and a growing group of mezzanine lenders has emerged.In the real estate area, a mezzanine loan is one that is intended to be junior and subordinate to the mortgage loan covering the property, yet is ahead of the equity and any equity investors.


Mezzanine lending has largely replaced, at least for capital market lending, second mortgage loans and other types of traditional subordinate lending.Mezzanine loans are especially attractive for properties that have untapped equity value with significant and stable cash flow.As properties subject to existing loans that cannot be prepaid (or cannot be prepaid without making an uneconomic prepayment fee) stabilize and increase in value, or are limited during the senior loan's underwriting process in the amount of financing proceeds that are obtainable, properties become attractive for mezzanine loans.


A mezzanine loan in the real estate context is a loan to the equity holders of the property-owning mortgage borrower, usually a limited partnership or a limited liability company.And, since mezzanine loans are riskier than senior mortgage loans, they have significantly higher interest rates and fees than senior mortgage loans.The mezzanine loan is then secured by a pledge of the partnership interests, the limited liability company membership interests or the other equity interests in the mortgage borrower.


Mezzanine lenders require that the mezzanine borrower be structured in the same manner as the underlying borrower in a CMBS financing is structured.The mezzanine borrower is thus required to be a bankruptcy remote, single purpose entity (SPE) with a laundry list of requirements and covenants in its organizational documents as well as the loan documents.These requirements seek to ensure that the borrower is and will remain a SPE and not file for bankruptcy or have its assets consolidated with those of its parent or other affiliate involved in the transaction in the event of such parent's or affiliate's bankruptcy.It is likely that the mezzanine lender will require the appointment of an independent director or special member at the appropriate level (e.g., for the borrower's general partner if the borrower is a limited partnership or for the borrower's managing member if the borrower is a limited liability company or the borrower itself if the borrower is a single member Delaware limited liability company).


These independent directors or special members will then be required to vote for or consent to a voluntary bankruptcy filing or other bankruptcy related action.(Without going into a lengthy discussion of the obligations of an independent director or special member to act as intended by the lender, at the very least they should ensure against an inappropriate bankruptcy filing, which a lender would likely define as one intended to hinder and delay enforcement of the loan.)The mezzanine lender will also often, at least in substantial transactions, require the mezzanine borrower to provide it with a non-consolidation opinion of counsel.


Mezzanine lenders will also require a non-recourse carveout guaranty from a financially responsible party or parties.Similar to those given in senior mortgage lending transactions, they provide for guaranties of any losses or expenses resulting from fraud, material misrepresentation, misapplication of insurance proceeds or condemnation awards, misapplication of security deposits, violations of the SPE covenants and representations, violations of transfer or subordinate mortgage or other debt restrictions, filing of any bankruptcy petition or taking certain other bankruptcy-related actions, and numerous other items.In addition, and as in senior mortgage loans, these guaranties often are structured to become full loan guaranties if there are breaches of certain of the non-recourse exclusions, such as the restrictions on violating SPE covenants, taking prohibited bankruptcy actions, and violating any of the transfer or debt restrictions.


Unlike a mortgage loan, mezzanine loans are enforced by a foreclosure under the Uniform Commercial Code (UCC) on the pledged equity interests given as collateral.These foreclosures are different than typical mortgage or deed of trust foreclosures.They are more intricate and the statutory procedures must be carefully followed.They are also usually faster and less expensive than mortgage foreclosures.There have not yet been many UCC foreclosures of these types of collateral, and, therefore, most mezzanine lenders and their counsel (as well as mezzanine borrowers and their counsel) have little experience dealing with the enforcement of defaulted mezzanine loans.


Upon successful completion of the UCC foreclosure, the lender, either directly or through a subsidiary entity or nominee, unless there is another purchaser at the UCC foreclosure sale, becomes the owner of the equity interests in the mortgage borrower, and thereby the owner of the mortgaged real estate.This creates some interesting situations.As the real estate owner and mortgage borrower, the mezzanine lender must now operate the property and service the senior mortgage loan, and it also must pay any and all other debts and obligations of the mortgaged borrower, or put its collateral/asset (i.e., the property) at risk.In order to minimize some of these risks, certain protective actions can be undertaken by the mezzanine lender when it is making its loan.


Since a mortgage is not given at the time of the mezzanine loan closing, a traditional mortgagee title insurance policy is not obtained by the mezzanine lender. As noted above, the mezzanine lender, if it enforces the pledge of its collateral, will likely succeed, directly or through a subsidiary or nominee, to the ownership position of the mortgage borrower.If that occurs, it will, at that time, have the benefit of the property owner's/mortgage borrower's title insurance policy. The mezzanine lender should therefore, when it is making its loan, make sure that the borrower has a satisfactory fee title insurance policy. The mezzanine lender should make sure that the fee title insurance policy is dated the date of the making of the mezzanine loan, not an earlier date, and is in a sufficient amount to protect its "equity investment." A policy from when the mortgage borrower acquired the property, and which, therefore, may be in too low an amount and also not contain any easements, declarations, liens, etc. recorded after that date, should not be acceptable to the mezzanine lender.


The mezzanine lender should also consider obtaining a mezzanine loan endorsement to the fee title insurance policy.This endorsement will provide for direct payment of a loss under the policy to the mezzanine lender, and also provide very important "non-imputation" coverage.This non-imputation coverage, which is issued based upon affidavits and indemnities given by the mezzanine borrower to the title insurance company, protects the mezzanine lender from the title insurance company denying liability under its policy to the mezzanine lender on the grounds that the lien or other matter creating or causing the loss was known to the insured (i.e., the property owning entity which is now owned by the mezzanine lender) provided it was not actually known to the mezzanine lender.


In addition to the protection afforded by the mezzanine endorsement to the owner's title insurance policy, appropriate UCC searches should be obtained by the mezzanine lender.And, for optimum protection, the mezzanine lender should consider requiring one of the new forms of UCC policies that are now being issued by several of the major title insurance companies.These new policies insure the pledge of the equity interests in the mortgage borrower given as collateral for the mezzanine loan.


In most mezzanine loan situations, especially where both the senior mortgage loan and the mezzanine loan are with capital market lenders, an intercreditor agreement is entered into between the senior mortgage lender and the mezzanine lender.One of the important items covered in this agreement is the mortgage lender's consent to the mezzanine loan.Since, as noted above, a foreclosure of the mezzanine loan will likely result in the mezzanine lender either directly or through a subsidiary entity or a nominee becoming the owner of the mortgage borrower, the mezzanine lender will want to negotiate provisions to ensure that lender's succession to ownership and control of the mortgage borrower through its enforcement of its loan will not trigger due-on-sale provisions or other defaults under the senior mortgage loan documents.The mezzanine lender may also seek to include a stand-still provision in the intercreditor agreement to grant the mezzanine lender time to enforce its collateral pledge and take over ownership of the mortgage borrower. While the mortgage lender, as the senior lender, will want to have control of numerous approval and consent matters (e.g., leases, budgets, insurance coverages, etc.), greater risk is arguably on the mezzanine lender and it will want to have control over many of these same matters, so there is significant tension between the two in this area.These as well as numerous other items are often negotiated in the intercreditor agreement.It is important to note that while these provisions seemingly are of interest only to the two lenders, many of them may impact the borrower.The borrower will have two lenders to work with, and while it may have negotiated certain provisions with one, that lender may have negotiated away some or all of those consent or approval rights to the other lender.The rating agencies also have numerous requirements with respect to certain mezzanine loan provisions as well as the intercreditor agreement.


If this is not complicated enough, CMBS pools have recently been divided and sold to greater degrees than ever before.The result is that in some transactions it is possible that the servicer or special servicer acting for the owners of a mortgage pool (or even multiple servicers and special servicers if ownership interests have been sold to multiple additional owners) may be involved in a CMBS mortgage loan transaction in addition to the anticipated senior lender and mezzanine lender.The legal obligations and responsibilities among the parties in these circumstances are just beginning to be discussed and determined.


The marketplace today often refers to preferred equity investments by a mezzanine-type lender as a mezzanine financing.In preferred equity, the lender makes a capital contribution to the mortgage borrower in exchange for an equity share in the mortgage borrower, with preferred rights of payment over other equity and with cash flow going first to pay the investor/lender a preferred return.While preferred equity has many characteristics similar to mezzanine lending, it is very different.Primarily, from the beginning, the investor/lender in a preferred equity investment has an actual equity position.Many mezzanine lenders have flexibility in making their loans and investments and can combine aspects of equity investments with their mezzanine debt transactions.For example, a mezzanine lender might structure its loan to provide a participation in profits in addition to a stated interest rate.


Mezzanine financing for real estate projects has developed as a result of the outstanding growth of the capital markets.It is likely to continue to expand, especially as more and more senior mortgage lending is provided by the capital markets, significant equity remains unfinanced and traditional second mortgage lending continues to be prohibited or severely restricted.Its growth will also be fueled by more investors entering the mezzanine lending market to invest their available capital in a high return type of lending.

Lester M. Bliwise is a Member in the New York office of Sills Cummis Epstein & Gross P.C.Mr. Bliwise is a member of the American College of Real Estate Lawyers and is a former chair of both the Real Property Law Section of the New York State Bar Association and the Section's Real Estate Financing Committee.

Please email the author at lbliwise@sillscummis.com with questions about this article.