Both mezzanine debt and subordinated debt are useful tools in real estate finance, as they both provide a form of secondary mortgage financing on projects. However, while mezzanine debt and subordinated debt are both secondary type loans, they also have important differences. The distinction is much more significant to the mortgage lender than to the borrower, though.
To understand mezzanine debt, subordinated debt and the distinction between the two, you first must understand real property liens. A lien is a legal claim or interest in collateral property belonging to the borrower. Mortgage lenders, including mezzanine and subordinated debt lenders, use liens to secure mortgage loans. Every lien on collateral has a priority interest, or priority rank, compared to other competing liens on the same collateral. Foreclosure on the lien with the highest priority will eliminate any other lien on the collateral, while foreclosure on a lower-level lien does not eliminate any senior, or higher level liens on the collateral.
Both mezzanine and subordinated debt provide junior liens to the lenders. This means that at least one other lien on the collateral has a higher priority than the mezzanine or subordinated debt. Foreclosure on that higher priority would result in the elimination of the mezzanine or subordinated debt.
Mezzanine debt is a type of mortgage loan used to cover the gap created by loan-to-value requirements on a first-priority mortgage loan. Most commercial mortgage lenders will only provide a mortgage loan for up to 70 percent of the value of the collateral. The borrower must come up with the remaining 30 percent. One of the ways borrowers come up with that remaining 30 percent is to use a mezzanine loan. This is a loan that is junior to the primary mortgage loan, which means the mezzanine loan is a higher risk for the lender. The mezzanine lender knows, at the time it issues the loan, that its lien on the collateral will be secondary, or junior to the first-priority mortgage loan. The lender accounts for this risk by charging a higher interest rate and/or higher fees than a standard first mortgage loan.
Subordination provides a way for a lien that would otherwise have first priority, by the voluntary consent of the lender, to become a second-priority lien on the property. Say a mortgage lender provides a first mortgage loan to purchase a property. The borrower later discovers that the property needs significant capital improvements to produce income. The first mortgage lender is unwilling to provide additional capital to finance the improvements. The borrower secures a loan from another lender to make improvements. However, the new lender will only provide the loan if it has a first-priority lien on the collateral. The first lender, understanding that the collateral is worthless without the needed improvements, agrees to subordinate its lien so that the borrower can obtain the second mortgage loan. The first lender signs a subordination agreement which gives the second lender the first lien position in the property. Like a mezzanine lender, the lender on the subordinated debt now holds a second-position lien on the property. The key distinction is that the subordinated debt lender did not know, at the time of issuing its loan, that it would hold a second-position lien.