Mezzanine debt and covenants

The capital stack is how a property's cost is paid for, from safest to riskiest: the senior mortgage at the bottom (paid first, lowest rate), then mezzanine debt or preferred equity, then the owners' common equity at the top (paid last, takes the first loss, keeps the upside).

A mezzanine loan fills a gap between what the senior lender will lend and what the owner wants to put in. It isn't secured by the property itself but by a pledge of the ownership interests in the company that owns the property, so if the borrower defaults, the mezzanine lender can take over that company (often much faster than foreclosing on a building). It's paid after the senior loan and before the equity, so its rate is higher. An intercreditor agreement between the senior and mezzanine lenders sets out who can do what if things go wrong.

Preferred equity sits in a similar place but is an ownership stake with a priority return, not a loan. Senior lenders often restrict or forbid other mortgages on the property, which is one reason the middle of the stack takes these forms.

With layers, tests are run on the combined debt: combined LTV (all debt ÷ value) and a combined DSCR. A senior loan at 60% LTV with a mezzanine loan of 15% means 75% combined LTV, and the equity cushion is only 25%.

value, noi = 20_000_000, 1_300_000
senior, mezz = 12_000_000, 3_000_000
senior_ds, mezz_ds = 900_000, 330_000
print(f"senior LTV {senior / value:.0%}, combined LTV {(senior + mezz) / value:.0%}")
print(f"senior DSCR {noi / senior_ds:.2f}x, combined DSCR {noi / (senior_ds + mezz_ds):.2f}x")

Covenants are the promises in a loan agreement. Financial covenants set a minimum DSCR or debt yield, or a maximum LTV, tested every quarter or year. Reporting covenants require rent rolls and financial statements on time. Negative covenants forbid things without the lender's consent: more debt, selling the property, changing the manager.

Breaking a covenant doesn't always mean default straight away. Many loans have a cash management trigger: if DSCR falls below, say, 1.15x, the property's spare cash is held in a lender-controlled account (a cash trap or sweep) instead of going to the owner, until the numbers recover. There's often a cure period, or the owner can pay down part of the loan to get back in line. Repeated or serious breaches can be events of default.