When modeling mezzanine financing, is the general rule to only pay down interest and any additional principal accrued as a result of not being able to fully service interest from previous periods but never pay down the original principal? Obviously this is not nuanced for every situation or term sheet from Mezz debt lenders, but generally speaking is the original loan proceeds (principal) not to be paid down?
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Leading off with a bit of general advice that will greatly help improve your career trajectory and compound how quickly you learn - whenever you are faced with a problem similar to this or you get stuck during any analysis, always ask yourself what you would do as the owner/investor.
Taking this step and really thinking through the options and their respective deal impacts will force you to holistically learn why the standard approach is the standard approach as well as (more importantly) why you should diverge from it.
In this particular example, it is helpful to think through why an owner/operator would want to either use the leftover cash to pay down the mezzanine debt or use it elsewhere. This is where the theory of opportunity cost of capital comes in - if you can borrow money at a lower cost then the return you can make using the cash elsewhere, you “win”. For example, if I can borrow money from the bank at a 2% rate and use that cash to make a 7% return then I’m enjoying a 5% spread, all while using less of my own money(!).
Now the key distinction in this example is that mezzanine debt typically comes with relatively high rates, right now it is ranging between a 12-15% interest rate depending on the deal, sponsor, etc. You can see that this is relatively close to the returns investors/operators expect on their equity capital so there is not much of an advantage to taking the leftover cash and using it elsewhere unless you are extremely confident in some high upside alternative investments (20%+ return). Also you can see that if you get “behind” on paying down this mezzanine loan that it would quickly compound and eat up a majority of the planned returns.
As such, the decision most owner/operators make is to pay down the mezzanine debt/equity principal as quickly as possible.
One thing to keep in mind is that depending on what you’ve negotiated this will be dictated and likely be a requirement in the loan documents/partnership agreement so it is worth checking to see what is in place for the deal in question.
In a senior/mezz scenario, most senior lenders wouldn’t let you pay down principal of the mezz prior to the senior getting paid off. (Unless you’ve negotiated this right at the time of closing). At best, a senior lender would allow a pro rata pay down.
So I’m your example, if there is enough funds from the property itself for the senior to get paid, but not the mezz and you are accruing interest on the mezz, there are two ways to “catch-up”. 1) you bring in funds from outside of the borrower and push them through the waterfall or 2) your property starts cash flowing again and leftover money starts being applied to the mezz accrual. Once the catch up is completed (essentially a cure of the default), then everything goes back to how it was before the default (e.g. the principal amounts don’t change).
I am also looking at modeling mezz to learn. It seems in general you would just pay interest payments, unless you have any leasing hurdle penalties which you would want to pay off sooner. So it seems the senior lender (as outlined in loan docs) won't allow you the ability to payoff anything before their loan is paid. So for example let's say you have a $10mm mezz piece (technically pref equity but acting as a loan) and $10mm senior loan that you used to cover a construction loan when you finished construction but due to delays you had to get the mezz piece to cover and pay it off.
If you mezz piece had a 2-3 year maturity and high interest rate in the 12-15% you would need to lease up the property and refinance the deal hopefully getting a lower cost of capital overall to cover the $20mm total debt cap right? And for example is it dependent on senior loan docs if the mezz piece had leasing hurdles you had to hit and if you didn't you had to pay say a $500k principal paydown. If you owed this paydown would you owe the $10mm senior and then the $500k paydown/payoff the total mezzanine loan?
Also am curious how common this is, at a smaller operator in a Tier 1/2 market and this obviously seems like a deal gone bad but has anyone seen this before where the capital stack is literally 50/50 senior to mezz (pref equity as a loan)?
Agreed with all of the feedback from the above, there are going to be a ton of nuances depending on the risk profile of the transaction, leverage levels and the inter-creditor agreements between the mezz and senior. From both the senior and mezz lenders POV, they want to minimize cash profit leakage to the borrower as little as possible to ensure the highest probability of payoff.
Also mezzanine debt is frequently structured with a total interest rate where only a portion is required to be paid and the remainder is accrued to the outstanding principal balance (increasing the next periods current interest payment).
Generally speaking though, mezz term sheets will typically have a legal clause similar to the below addressing both cash flow from operations as well as during a capital event (i.e. sale/refinance):
Interest Rate
The Interest Rate payable on the investment will be 12% per annum, comprised of the following:
Sale or Refinance Waterfall
Upon a capital event or maturity, proceeds shall be applied as follows:
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