Mezzanine Debt and Gap Capital

Mezzanine capital sits between the senior mortgage and the sponsor's equity. When a first mortgage lender funds sixty-five percent of cost and the sponsor can raise twenty percent, mezzanine debt covers the remaining slice — subordinate to the senior loan, senior to the equity, and priced accordingly. In real estate it is most often secured not by a mortgage on the property but by a pledge of the equity interests in the borrowing entity, which allows the mezzanine lender to foreclose on ownership of the entity far more quickly than a mortgage foreclosure would permit. Preferred equity achieves a similar economic result through a different legal structure.

The decision to use mezzanine capital is a math problem: does the blended cost of senior plus mezzanine still produce an acceptable return on the reduced equity check, and is the sponsor comfortable with the control rights the mezzanine lender will negotiate? Every mezzanine deal requires an intercreditor agreement between the senior and subordinate lenders governing cure rights, standstill periods and transfer conditions, and negotiating it takes time. Some mezzanine lenders also seek an equity kicker or participation in residual profit above a return threshold. Used well, mezzanine debt lets a sponsor control a larger asset without diluting ownership through a joint venture partner.