“The biggest benefit mezzanine debt provides is reducing the amount of equity required in the transaction,” says Koontz. “Mezzanine investors are looking for 12 to 20 percent returns (internal rate of return) and in many cases a percentage of the profit, but still less than what an owner would require”. While mezzanine debt is more expensive than bank debt, it is not as rigid. “Generally, it shares the same covenant package as a bank deal, but the requirements for approval are not as strict. The financing typically does not require that a 2nd mortgage be placed on the real estate, but instead, on a lien on the holding company if required.”
Typical Financing Structure
Let us assume a developer is purchasing an apartment building for $3 million and needs $1 million to rehab the building to do a condo conversion. A bank would provide senior debt of about 80% at around 6% to 9% with the requirement of 20% down from the developer. The developer is capable of putting down 10% and acquires a mezzanine loan of 75% the required equity for which he pays 10% and 25% of the profit. The sell out on the project as condo is $6 million, yielding a profit before taxes of $1.5 million after debt services. The mezzanine lender will get $375k of the profit, giving the developer a profit of $1,125,000 for an investment of only $200,000. If he had brought in a 75% partner, his profit would only be $375,000.
Other People’s Money, “OPM”, is the way of the world with today’s developers and a way where all parties can profit.
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