Mezzanine debt

Mezzanine debt fills the gap when a senior lender will not fund as much of a project as the developer needs and the developer does not want to raise all of the difference as equity. It is repaid after the senior mortgage but before equity holders receive anything. Because it takes more risk than the senior loan, it charges a higher interest rate; because it takes less risk than equity, it costs less than equity.

Mezzanine loans are usually secured by a pledge of the ownership interests in the entity that owns the property, not by a mortgage on the property itself. If the borrower defaults, the mezzanine lender can take control of the owning entity, stepping into the owner's shoes while the senior mortgage stays in place. Senior lenders typically require an agreement with the mezzanine lender spelling out who can do what in a default.

Assume a $24,000,000 project where the senior lender will fund 65%, or $15,600,000, and the developer arranges a mezzanine loan for a further 10%, or $2,400,000, at a higher rate. The equity requirement falls from $8,400,000 to $6,000,000. The blended cost of capital may go up or down depending on the rates, but the developer has less of its own money at risk, and the project as a whole is more leveraged.

For housing costs, mezzanine debt is one way the capital stack is arranged, not a separate source of cost. Every layer must be paid from the building's income, and the more layers that expect a return above the senior loan's rate, the higher the net operating income, and therefore rent, the building must produce. It also raises the risk of the whole structure, which is why it is more common in some cycles than others. Preferred equity plays a similar role with a different legal form.