What Is a Mezzanine Loan?

A mezzanine loan is a type of financing used in commercial real estate. These loans are somewhat equivalent to second mortgages on homes. For investors, mezzanine loans may offer an attractive combination of higher yields and asset-backed safety. Mezzanine debt is most often available to individual investors as a portion of a packaged debt investment.

Mezzanine Debt Overview

Mezzanine debt is the level of debt between senior or asset-backed debt and corporate equity. A mezzanine loan typically is used to borrow additional money against a commercial property above the first mortgage on the property. For example, the purchase of a $10 million property could be funded with a $5 million mortgage, a $2.5 million mezzanine loan and $2.5 million of cash. The mezzanine debt is not secured by the property but is instead secured by the stock of the purchasing company. If the borrower of a mezzanine loan defaults, the lender can go after the whole company rather than just the property against which the loan was made.

Uses of Mezzanine Loans

Mortgage lenders for large commercial properties -- such as pension funds or commercial banks -- often will limit a mortgage to 50 or 60 percent of the property value. A mezzanine loan can be used to reduce the amount of cash the buyer needs to complete the purchase. A mezzanine loan also can be used to pull equity from an already-owned commercial building with a low first mortgage-to-value ratio. Mezzanine debt may be used as bridge funding while a property is improved, renovated or built. After the work is completed, the mezzanine loan is replaced by a new first mortgage based on the higher value of the property.

Mezzanine Loan Features

Mezzanine loans typically have shorter terms than commercial mortgages -- a maximum term of five years compared to 10 to 15 years for a commercial mortgage. Often, the borrower is just required to make interest-only payments and either pay off or renew the mezzanine loan when it matures. A borrower will pay -- and investors earn -- a significantly higher rate of interest on a mezzanine loan. If the rate on a first mortgage for a commercial property is 6 percent, a mezzanine loan may have an interest rate of 10 percent or higher. The minimum size for a mezzanine loan is $1 million to $2 million, depending on the lender.

Investing in Mezzanine Debt

Investors can participate in the high yields from mezzanine loans through investments that either make mezzanine loans or hold this type of loan in a portfolio of debt securities. Real estate investment trust -- REIT -- companies specializing in commercial property debt often make mezzanine loans. Loan participation-focused closed-end funds -- CEF -- may also own mezzanine debt. Both REIT and CEF shares trade on the stock exchanges and can be purchased through a stock brokerage account.