The two LTVs that define a mezzanine position, and the value decline at which it actually starts to lose money.
A mezzanine loan's attachment point is the senior loan divided by property value; its detachment point is the senior loan plus the mezzanine divided by value. On an illustrative $100 million property with $55 million of senior debt and $15 million of mezz, the position attaches at 55.0 per cent and detaches at 70.0 per cent LTV. That suggests a 30.0 per cent value cushion, but once sale costs and a year of accrued interest are counted the mezz takes its first loss after an 18.5 per cent fall.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The case is a stabilised property financed with an interest-only senior loan and an interest-only mezzanine loan behind it. Figures are in millions and illustrative. In an enforcement, both lenders are assumed to accrue twelve months of unpaid interest before the property is sold, and selling costs, fees and protective advances absorb 8 per cent of value.
| Input | Value |
|---|---|
| Property value | 100 |
| Net operating income | 6.0 |
| Senior loan, interest-only at 6.0% | 55 |
| Mezzanine loan, interest-only at 11.0% | 15 |
| Sale and enforcement costs, % of value | 8% |
| Months of unpaid interest before sale | 12 |
Attachment point = senior / value = 55 / 100 = 55.0%
Detachment point (last-dollar LTV) = (senior + mezz) / value = 70 / 100 = 70.0%
Thickness = 70.0% - 55.0% = 15.0% of value; equity below the mezz = 30.0%
Debt yield at the senior = 6.0 / 55 = 10.9%; at the detachment point = 6.0 / 70 = 8.57%
Interest cover: senior 6.0 / 3.30 = 1.82x; senior and mezz 6.0 / 4.95 = 1.21x
In Excel, with value in B2, senior B3 and mezz B4: =B3/B2 and =(B3+B4)/B2
The ratios at the two points describe different risks. The senior lender, at 55.0 per cent and 1.82 times cover, has a loan that survives a large income fall. The combined stack, at 70.0 per cent and 1.21 times, does not: a modest drop in NOI stops the mezz coupon first. The blended coupon on the combined debt is 7.07 per cent: the rate a single whole loan at 70.0 per cent LTV would have to carry to cost the borrower the same.
The 30.0 per cent equity cushion is measured at par. In a default, three things erode it before the mezz is paid: the senior loan's unpaid interest ranks ahead, the mezz's own unpaid interest enlarges its claim, and selling costs come off the top.
Senior claim = 55 + 12 months x 3.30 = 58.30
Mezz claim = 15 + 12 months x 1.65 = 16.65
First mezz loss when value x (1 - 8%) < 58.30 + 16.65 = 74.95, so value < 81.47: a decline of 18.5%
Mezz wiped out when value x (1 - 8%) < 58.30, so value < 63.37: a decline of 36.6%
On paper the mezz is safe until values fall 30.0 per cent and gone at 45.0. In an enforcement it starts losing at 18.5 and is gone at 36.6. The real cushion is about three fifths of the headline one.
| Value decline | Value | Net proceeds | Senior recovers | Mezz recovers | Mezz recovery | Mezz loss |
|---|---|---|---|---|---|---|
| 0% | 100.0 | 92.0 | 58.3 | 16.65 | 100.0% | 0.00 |
| 10% | 90.0 | 82.8 | 58.3 | 16.65 | 100.0% | 0.00 |
| 20% | 80.0 | 73.6 | 58.3 | 15.30 | 91.9% | 1.35 |
| 30% | 70.0 | 64.4 | 58.3 | 6.10 | 36.6% | 10.55 |
| 40% | 60.0 | 55.2 | 55.2 | 0.00 | 0.0% | 16.65 |
The row that should worry a mezz investor is the 30 per cent decline. Value has fallen exactly to the detachment point, the level at which the mezz looks fully covered, and it recovers 36.6 per cent of its claim. Mezzanine losses are steep because the tranche is thin: 15.0 per cent of value, so each further point of decline takes a large share of it.
In practice a mezz lender rarely waits for the senior to sell. Its usual remedy is to take control of the borrowing entity and keep the senior loan current, which avoids some costs but requires new cash. The arithmetic above is the floor the mezz is negotiating against when it decides whether to step in.
The cushion also shrinks with time in default. Every extra month before the sale adds senior interest that ranks ahead and mezz interest that enlarges the claim, while the costs of protecting the asset rise. A mezz underwritten on a short enforcement timetable should be tested on a longer one, because in a stressed market the sale is slow precisely when values are weak. The detachment point does not move; the loss threshold does, and always in the wrong direction for the mezz.
The frequent error is reading the detachment point as the loss threshold. It is a par measure taken on the day of closing. Credit papers that describe a 55 to 70 per cent mezz as protected by "30 per cent of equity" overstate the protection by more than half, because costs and the senior's accruing interest rank ahead. The second error is pricing the mezz on its coupon without its position: 11.0 per cent sounds rich, but the position loses money in any scenario worse than about a one-fifth fall in value, a decline that any downside case for a leveraged property should be expected to test.
Compute attachment and detachment from par, then recompute the cushion on claims after costs and accrued interest: 18.5 per cent rather than 30.0 here. The intercreditor and the structure that sits behind a subordinated position are among the working documents in the free workbooks for this book. For the sponsor's side of the same layer, see mezzanine against preferred equity.
It is the detachment point: senior debt plus the mezzanine loan divided by value. With $55 million senior and $15 million mezzanine on a $100 million property, last-dollar LTV is 70.0 per cent. It shows how much equity sits below the mezz, here 30.0 per cent, before costs and accrued interest reduce it.
NOI divided by senior plus mezzanine debt. On $6.0 million of NOI and $70 million of total debt it is 8.57 per cent, against 10.9 per cent at the senior attachment. Combined interest cover is 1.21 times, against 1.82 for the senior loan alone, which is why the mezz carries the default risk.
Less than the detachment point suggests. On the illustrative loan a 30 per cent fall takes value to exactly the 70.0 per cent detachment, yet after 8 per cent sale costs and a year of accrued interest the mezz recovers 6.10 of a 16.65 claim, 36.6 per cent, a loss of 10.55.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 453 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.