Real Estate Finance: Mezzanine Loans Bridge the Equity Gap

Conventional Mortgage Financing

Local and foreign developers have traditionally combined their own capital and conventional mortgage financing from local or foreign banks to fund real estate ventures in Hong Kong and China. As a result of Asia's financial downturn in 1997, many financial institutions have been restricted from investing heavily in real estate by government regulations and by their own credit guidelines. Many developers around the region have therefore been forced to find creative financing techniques for real estate ventures.

In Asia, several investment funds and financial institutions have opted for capital structures that combine traditional mortgage financing with mezzanine loans as a way of achieving the loan-to-value ratios that make real estate ventures financially viable for developers. The typical mezzanine lender views itself as a cross between debt and equity funding because of the high loan-to-value ratio that the lender advances against a given project. As a result, the lender receives a higher coupon on its loan for assuming a riskier position.

Since many real estate developers have a very modest capital structure, having a highly leveraged structure may be the only way to develop a project in many Asian countries. By using a senior mortgage loan and a mezzanine loan, the borrower can achieve a weighted, blended average interest rate. The bifurcation of the loans and the risk profile creates an opportunity for entrepreneurial lenders or investment funds to invest in the riskier mezzanine portion of the capital structure. The bank, syndicate or securitization investment vehicle retains the senior secured portion and the opportunistic lender retains the more highly leveraged piece.

Dividing the loan into a low leverage, senior secured piece and a high leverage, mezzanine tranche allows the financial institutions to underwrite the whole deal. This satisfies the stricter credit requirements of financial institutions, as well as the needs of the real estate developer. In the US, the mezzanine loan market is well developed and