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Mezzanine Financing or Mezzanine Debt is another name for junior debt that has a subordinate position to the senior debt, and that typically commands a higher interest rate.

Mezzanine debt is commonly used in commercial real estate and it's the commercial equivalent of taking out a second loan or a home equity loan on a home, but it's often structured with a much wider variety of potential loan terms including an option to be converted into equity

Senior debt takes priority over junior debt because it is first in line to receive the income and also first in line to receive any proceeds should the project fail and need to be liquidated.

Junior debt or mezzanine debt is next in line in priority and is typically more expensive because of that higher risk. Often senior debt holders will only lend up to maybe 60 or 70% of a project, and unless the equity holders are able to come up with that additional 30 to 40%, then mezzanine or junior debt is necessary.

Sometimes junior debt can be called bridge financing because it bridges that gap between the senior debt and the equity.
Let me show you an example.

Sometimes novice investors will get scared of the prospect of using mezzanine debt because of the higher interest rate.

But if you dig a little bit deeper into the math, you'll see, it's not as daunting as it might appear at first.

Imagine we have a $1 million property.

The buyer only has 200,000 to put down as a down payment.

The lender will only lend $700,000, which leaves a $100,000 gap that the borrower can fill with a mezzanine loan.

Now imagine the senior loan has an interest rate of 4% amortized over say 25 years. And the mezzanine loan has an interest rate of 10%.

It might seem like that's a very expensive loan, but if it allows the borrower to get the deal done, it might be worth it. And it might not be as expensive as you think.

Let's take a look.

If the senior loan is amortized over 25 years. That would be 300 months. It has an interest rate of 4% per year. We divide that by 12 to get the monthly interest. The loan amount would be 700,000. That's our present value that gives us a payment of $3,694.85 per month. Let's look at the same thing for the mezzanine.

The mezzanine loan has the same terms, 300 months or 25 years, but an interest rate of 10%, of course, we divide that by 12 because we need the monthly rate and we put in the loan amount for a hundred thousand and we get a monthly payment of $908.75

Well, if we add those two, that means we have a total monthly payment of $4603.56 on $800,000 worth of debt.

If we back into the interest rate solving for "i" we get 0.4035, which is our monthly interest rate. So we have to multiply that by 12, and then we see that we have a 4.84% interest rate combined.

And what we call that is the Weighted Average Cost of Capital

So whenever you're analyzing a deal and looking at the potential to use mezzanine debt, in addition to the senior debt, don't be daunted by the higher interest rate until you calculate the weighted average cost of capital.

Because in this particular case, the difference between the 4% on the senior loan and the weighted average cost of capital of 4.84 is not that much and could potentially make it so that the borrower can get the deal done, where without the mezzanine financing, they would not have been able to.

If you made it this far, I want to thank you for watching. And if you enjoyed this, please like and subscribe and all that. And definitely leave me a note in the comments, if you have questions or if you'd like to see other videos.

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