Real estate transactions are usually financed with two sources of capital – first mortgage financing and equity. But what do you do when there is a gap between the amount your bank is willing to lend in a first mortgage position and the amount of equity you want or can invest?

Too much equity and your returns go down. Not enough equity and the deal might not get done. While it is certainly possible to negotiate seller financing in the case of a property purchase, but what do you do if you are developing a piece of property and there is no seller?

As an example, consider a project where the mortgage lender will only lend 60% of the cost. If your return expectation were built around 20% or 25% equity contribution, you have a financing gap that needs to be filled.

Consider using a slice of capital known as mezzanine. Mezzanine is defined as “a low story between two others in a building, typically between the ground and first floors”. In this same context you can think of mezzanine financing as that capital that sits between the equity in a deal and the first mortgage.

Mezzanine financing is a debt instrument that is higher yielding – read more expensive – than first mortgage financing, but lowering yielding, cheaper, than equity. The reason that mezzanine is more expensive than traditional first mortgage financing is because the first mortgage lender has a preference over the junior capital (the mezzanine and equity) in the event of liquidation. Conversely, the mezzanine has a preference over the equity in the event of liquidation. Mezzanine financing can either be secured by a second mortgage or be unsecured.

The returns for mezzanine are generated through a combination of higher yielding coupon and a participation in the equity of the project. There is a balance in the ratio of the how the mezzanine return is generated. Part of the equation is based on the mindset of the mezzanine investor. Some investors are more equity oriented, and so will accept a lower coupon for more of the upside of a transaction. Other mezzanine investors are more debt oriented and will want to generate more of their return from the coupon.

If your mezzanine investor is more debt oriented, but there is a limit on the amount that can be paid on the mezzanine instrument, due either to the cash flow of the deal or covenants of the mortgage lender, you’ll have to partition the coupon into cash-pay and accrued payments. To the extent there are accrued payments, you should be aware that i) the accrued interest payments will have a preference to distributions to the equity – meaning that they get paid first; ii) since some of the payments are pushed out to the maturity date of the mezzanine, you will probably have to give up more equity than if all of the interest payments were paid currently; and iii) be careful in structuring the accrued payments to avoid, if you can, compounding of interest payments.

Institutional investors regularly participate in the mezzanine debt offering of real estate transactions, but these are typically large transactions. For smaller deals, look to tap into your network of individual investors, some of which may find the current yield potential secured position more interesting than the equity of a transaction. And, of course, when you go out raising capital, whether it’s debt of equity, you’ll want to present your investment opportunity with a private placement memorandum.