As non-bank lenders have expanded their reach in the post-pandemic era of commercial real estate financing, so too have mezzanine loans and preferred equity structures as a supplement to conventional mortgage financing.

Mezzanine financing in commercial real estate is a loan structure whereby a lender makes a loan for a real estate project secured by a pledge of equity interests in the legal entity that owns the property. It is called “mezzanine” because it occupies a middle layer between traditional mortgage financing secured by a first lien security interest the real property and common equity that is the first money at risk in a distressed situation.  

Developers use mezzanine financing to bridge the gap between the loan amount a senior mortgage lender is willing to make and the amount of equity a developer is seeking to contribute. As an example, a senior mortgage lender may offer a 55% loan-to-value (LTV) ratio, with a developer looking to finance 75% of the value, leaving a 20% gap where mezzanine financing can come in.

There are traditional mortgage lenders that will take a pledge of equity in addition to their senior mortgage interest as additional credit enhancement for its loan, but for purposes of this article, I will focus on mezzanine loans from third-party capital providers, not a single capital provider with two different forms of security.

One of the most critical documents to understand in these transactions is the intercreditor agreement between the senior mortgage lender and mezzanine lender. At its core, the intercreditor agreement is all about the parties' rights with respect to control in a distress situation.

Below are some key negotiating points and perspectives on those points from each of the parties involved:

1. Core Interests in Intercreditor Agreement: Given that the intercreditor agreement primarily addresses rights and remedies should a deal go south, the parties' interests in this document generally are as follows:
   
   • Mortgage Lender: To not lose principal and have a clear path to foreclosure should there be a default.
   • Mezz Lender: To not be wiped out by the first mortgage lender in a foreclosure and to protect principal by active intervention in distress situations.
   • Borrower: To not be caught between the two lenders with conflicting demands.
2. Standstill Period: Foreclosure of a pledge of equity under a mezzanine loan is much faster than a traditional foreclosure process. The timing differences vary by state, but across the board UCC foreclosures are faster than mortgage foreclosures. For that reason, after a default under a mezzanine loan, the mezzanine lender is typically required to observe a standstill period before exercising its remedies.
   
   • Mortgage Lender: To enforce its own foreclosure remedy without a mezzanine UCC foreclosure or a change of ownership getting in the way. Also, to maintain quality of the ownership group.
   • Mezz Lender: To keep the standstill period as short as possible and have the right to exercise its remedies to take over ownership of the equity.
   • Borrower: To avoid inconsistent or conflicting demands and enforcement pressures from both lenders and to stretch the standstill period and the time generally for the lenders to enforce their remedies. Borrowers typically want a 90+ day standstill period.
3. Mezzanine Lender Cure Rights: Mezz lenders want every option they can have to rescue their loan if it is looking like a senior lender intends to foreclose. For that reason, mezz lenders often negotiate a right to cure defaults under the senior loan. Mezz lenders' extended cure periods are typically: 5 business days for monetary defaults and 30-60 business days for non-monetary defaults, in each case after expiration of the cure periods under the senior loan documents.
   
   • Mortgage Lender: Open to a white knight coming in to cure mortgage defaults, but not endless delay. Wants notice and cure periods clearly defined and short.
   • Mezz Lender: Wants flexibility and options to cure, while also recognizing that it may not be prudent for it to "throw good money after bad" trying to fix a problem.
   • Borrower: Somewhat agnostic, but needs to recognize that the mezz lender's costs to cure could be added to the mezz loan balance.
4. Mezzanine Lender Purchase Option: Similar to the mezzanine lender's cure right above, the purchase option gives the mezzanine lender a chance to double (or triple) down and buy out the senior mortgage lender, typically at par plus accrued interest and fees, after an event of default under the senior mortgage loan.
   
   • Mortgage Lender: This is an easy give, as the senior mortgage lender wants repayment as its principal objective. If there are any prepayment fees, the lender will want to make sure those are included.
   • Mezzanine Lender: The same considerations above apply in "throwing good money after bad", but this option allows the mezz lender to perhaps buy itself some time and figure out a longer term solution to the problem without the pressure of a mortgage foreclosure looming.
   • Borrower: Borrower's perspective on this will depend on context, the relationship it has with each lender and the mezz lender's intention.
5. Mezzanine Foreclosure Conditions: As a precondition to enforcing remedies under the mezzanine loan, the mezz lender may be required to jump through certain hoops, including evidence of the new owner's capabilities, a replacement guarantor, additional cash reserves or a lender-approved property manager.
   
   • Mortgage Lender: To maintain quality of sponsor and maintain as much discretionary control in the situation. [As a side note, having a well-qualified mezzanine lender that could take over in the event of a distress situtaion is often framed as an advantage in underwriting for a senior mortgage lender.]‍
   • Mezz Lender: To have clear expectations and ideally a pre-approved set of objective criteria that does not include a lender approval right.
   • Borrower: Somewhat agnostic, but should verify that the mezz loan foreclosure procedures are consistent with the underlying mezz loan documents.

There are a number of other provisions that are critical to negotiate, including with respect to loan document modifications, subordination, bankruptcy rights, loan transfer rights, notices and operational covenants.

As a general matter, adding a mezzanine loan to the capital stack can increase leverage and provide greater returns for a sponsor while also adding to the complexity, particularly in a workout situation. Some mezz lenders argue that their participation enhances the value of the deal to senior lenders due to the additional oversight and quality of operator to step in should things go south, while senior lenders recognize that higher leverage means less free cash flow available to service its debt. While borrowers may not be a party to the intercreditor agreement, they have an interest in making sure that it is clear and works from a practical perspective, as it can materially affect the borrower's flexibility in a workout, the identity of a future controlling party and the speed with which remedies can be enforced.

If you are considering a financing structure involving a mezzanine loan, please do not hesitate to reach out to laura@maherlawpllc.com to discuss further. Our firm has significant experience in structuring and closing these loans throughout the country.

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