Mezzanine Financing. Steven Horowitz and Lise Morrow. Traditional real estate financing has been based on the grant to one or

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1 Mezzanine Financing By Steven Horowitz and Lise Morrow Traditional real estate financing has been based on the grant to one or more lenders by the property-owning borrower (the Mortgage Borrower ) of one or more mortgages on the applicable property (the Mortgaged Property ) as collateral for one or more loans. While many real estate loan transactions involve only a senior mortgagee (the First Mortgagee ), it had been fairly common until recent years for the Mortgage Borrower to obtain higher loan proceeds by also granting a second mortgage on its property to a subordinate lender (the Second Mortgagee ). This pattern of lending raises the question of whether the Mortgage Borrower is thereby over-leveraged and unable to support the combined debt burdening the Mortgaged Property. One common measure of loan underwriting entails the so-called loan-to-value ratio ( LTV ), pursuant to which a First Mortgagee would limit its loan proceeds to, say, no more than 65% of the appraised value of the Mortgaged Property. A Second Mortgagee, however, may loan additional amounts, up to perhaps 90% of the Mortgaged Property s value, at a higher interest rate. The First Mortgagee, of course, has the most secure rights of recovery against the Mortgaged Property, followed in priority by the Second Mortgagee and occasionally third mortgagees. However, the use of subordinate mortgages has become less common during the past decade, as many first mortgage lenders have been sensitized to the pitfalls and increased difficulties of foreclosing on properties, which are also subject to a second

2 mortgage. Specifically, Second Mortgagees often have the financial wherewithal and incentive to delay and obstruct a first mortgage foreclosure, even in circumstances where the underlying Mortgage Borrower does not have such capacity. This phenomenon was particularly evident in the early 1990 s when many first mortgage lenders sought to foreclose on defaulted loans secured by properties, which had declined in value. Moreover, in transactions involving possible securitization of senior mortgage financing, rating agencies have been particularly dubious about the risks posed by subordinate mortgages. At the same time, of course, property owners may often want to borrow funds in excess of that available through first mortgage loans. The real estate capital markets have thus seen the development of Mezzanine Loan techniques in which non-mortgage subordinate financing has been provided to real estate owners. Using such devices, the parent company of a Mortgage Borrower can obtain higher loan proceeds without subjecting a First Mortgagee to all of the undesirable features of second mortgage financing. The key to mezzanine financing is the creation of structural subordination in the entities, which comprise the borrowing group. In a simple case, the Mortgage Borrower would be a limited partnership, which owns the Mortgaged Property; the Mezzanine Borrower would be the holder of a 99% limited partnership interest in the Mortgage Borrower (the property-owning limited partnership). The collateral for the Mezzanine Loan would be the pledge of such limited partnership interest to the Mezzanine Lender. Accordingly, the Mezzanine Lender would have a claim against the equity interest in the Mortgage Borrower, but would have no direct claim against the Mortgaged Property or the Mortgage Borrower and no right to make a claim against either

3 in the context of a first mortgage foreclosure. When coupled with a variety of other protections in the organizational structure of the Mortgage Borrower, a bankruptcy of the Mezzanine Borrower (due, for example, to its inability to repay the Mezzanine Loan) would not trigger the bankruptcy of the Mortgage Borrower. Accordingly, the jargon in the industry states that the Mortgage Borrower is a bankruptcy-remote entity or that it is bankruptcy-remote from the Mezzanine Borrower. That legal consequence reflects a key advantage of mezzanine financing arrangements as compared to the traditional combination of first and second mortgages. For such reasons, the combination of mortgage and mezzanine financing has been increasingly favored as a method to obtain higher levels of loan proceeds, especially in transactions involving mortgage securitization and/or the pooling of loans for sale in the secondary market. As this market has evolved, rating agencies have played a greater role in determining the structure of the subordinate financing and in encouraging the use of mezzanine financing as opposed to subordinate mortgage financing. Indeed, the rating agencies have published guidelines indicating acceptable methods of structuring mezzanine financing, and describing factors which may adversely affect the benefits flowing to the First Mortgagee. From the borrower s perspective, the use of mezzanine financing enables it to obtain flexible loan structuring and higher loan proceeds. The loan can be closed simultaneously with (or following) mortgage financing. In addition, such financing facilitates a transaction when private or public equity are either unavailable or unsuitable for the borrower s needs. However, mezzanine loans come at a cost, since a mezzanine lender will seek a higher return on its investment since its loan will not be secured by any

4 real property collateral. By adding a second lender, the borrower s conduct of its business is also somewhat more complex, since mezzanine lenders, just like mortgage lenders, will require certain remedial rights as well as control over the borrower s affairs. Moreover, mezzanine financing can complicate mortgage loan negotiations by virtue of the need for the two lenders to negotiate an intercreditor agreement. Since mezzanine loan obligations are repaid only with excess cash flow after payment of mortgage loan debt service, taxes, insurance, operating and capital expenses, the interests of the two lenders may conflict. How is Mezzanine Financing Structured? When a borrower and a lender commence discussion, one key decision to be made is whether the borrower s desired level of loan proceeds can be satisfied solely by first mortgage financing. If they determine that mezzanine financing is required, the structure of such financing may take the form of a conventional mezzanine loan, preferred equity or a combination of both. 1. The Mezzanine Loan In the conventional mezzanine loan, the mezzanine lender loans the additional funding to an intermediate holding company which is either the parent of the mortgage borrower or some other upper-tier entity indirectly owning the passive equity interest (e.g., a limited partnership interest) in the mortgage borrower. As security, the mezzanine borrower grants an equity pledge of its interest in the mortgage borrower; in addition, the parent company of the mezzanine borrower grants an equity pledge of its interest in the general partner of the mortgage borrower (assuming a limited partnership

5 borrower). The pledged interests, which include the right to distributions of income from the mortgaged borrower, constitute the source of repayment of the mezzanine loan. In some transactions, the mezzanine loan may also be secured by a guaranty from the ultimate parent entity of the mortgage borrower. The mezzanine lender s position is thus sandwiched below that of the senior mortgage lender but above that of common equity. The chart below illustrates the typical mezzanine loan structure. (Note that it has become increasingly common for mezzanine as well as mortgage borrower-entities to be structured as single-member limited liability companies, often organized in Delaware.)