Under a traditional loan agreement, the borrower will sign a promissory note which is secured by a mortgage. The mortgage, being in favor of the lender, is a lien and an interest in the real property. But you already knew that. This is the United States of America, so of course there are other (more creative, exciting and aggressive) forms of financing. One such form is known as Mezzanine or ‘Mezz” Financing.
What is a Mezzanine Loan?
Under a Mezz Loan, the lender agrees to provide the borrower with funds in exchange for an unsecured equity interest in the borrowing entity. Therefore, if the borrower fails to pay back the loan the Mezz Lender takes over the % interest in the borrowing entity’s assets. For example, starting with the following facts:
- Borrower owns a South Beach condo resort building currently worth $50,000,000
- Bank of the Nation has a First Mortgage on the property for $40,000,000
- Community Bank has a Second Mortgage on the property for $6,000,000
- The current value of the property minus the debt/mortgages on the property is $4,000,000. Therefore, there is $4,000,000 worth of equity in the property.
Now, the current owner of the property wants to finish the resort by constructing a $10,000,000 boat dock/marina. Most lenders would not make this loan, as there is only $4MM worth of remaining equity in the property (not to mention, the project would then be fully leveraged). Titan Investments agrees to loan the owner $10,000,000, but rather than obtaining a mortgage on the property, Titan requires a 25% annual interest rate and a pledged 20% equity interest in the borrower entity’s assets. If the borrower does not pay back the loan (with interest), Titan may seek to obtain collection via the other properties owned by the borrower and/or other assets/revenue streams they may have.
The Uniform Commercial Code
It’s important to note that a Mezzanine loan is usual not an interest in the real property (it’s not a mortgage), it’s an intangible interest in the borrower’s entity. Such interests are therefore governed by the Uniform Commercial Code (“UCC”) and must be therefore administered accordingly.
There are two Articles of the UCC that cover interests in a borrower’s entity: Article 8 and Article 9. Article 9 applies to interests in Limited Liability Companies and Partnerships. Article 8 applies to equitable interests in a Corporation. Not to get into the details, but an interest classified under Article 9 is considered a “Security Interest” where an interest under Article 9 is simply and “Intangible Interest” – more on this shortly.
ALTA 16 Mezzanine Endorsement
Like most owners of real property, the Mezz Lender will want some for of Owner’s Policy coverage in the event of a title loss/claim. Where the fee-simple owner is to be insured under a standard Owner’s Policy, the Mezz Lender may get coverage via an ALTA 16 Mezzanine Endorsement.
The requirements for an ALTA 16 Mezzanine Endorsement are as follows:
- An LLC or Partnership must amend their Operating Agreement/Partnership Agreement to explicitly state that they’re opt-ing in to have their equity interest governed by Article 8, rather than Article 9. This is important, as the UCC Loan Policy will insure the Security Interest (not the intangible interest). There must also be an Article 8 Proxy Agreement which gives the sole right of the lender to Opt-Out of Article 8 in the off chance that the LLC/Partnership subsequently attempts to modify their Operating/Partnership Agreement back to Article 9 governing.
- The Mezz Lender’s interest in the entity must be perfected in order to solidify priority to subsequently filed interests. The Mezz Lender should be provided with a Control Agreement or possession of certificates in the borrowing entity to perfect their interest.
Not all states (Florida included) offer the Mezzanine Endorsement. Check with your state underwriter for more information.
UCC Insurance Requirements Simplified
Like most loans, the borrower will want insurance that their security (whether in the real or intangible property) is valid. Where a standard Loan Policy provides this form of coverage for a real property interest (the mortgage), a UCC Loan Policy will provide coverage that the lender has a proper interest in the borrowing entity.
UCC Insurance is a different animal than a typical Owner’s Policy. Make sure to consult your underwriter when considering a UCC Loan Policy.