Five mistakes that borrowers should avoid with mezzanine real estate financing

Key takeaways

In this blog post we discuss five mistakes that real estate investors should avoid when using mezzanine financing and provide solutions how to address them:

1. Unclear financing purpose: Without a clear strategy, capital may be used inefficiently
2. Lack of an exit strategy: An unclear repayment plan can lead to financial bottlenecks
3. Unrealistic timelines: Banks and lenders require sufficient time for due diligence
4. Ignoring regulatory risks: Changes like Basel III can impact financing plans
5. Lack of overview of debt structure: Without a complete overview, liquidity issues may arise

Introduction

In our recently published article on subordinated mortgages, we discussed why borrowers choose subordinated mortgages for their real estate portfolios. This article focuses on the challenges that borrowers and real estate investors face when utilising subordinated financing. Specifically, we highlight five common mistakes that borrowers make – and how to avoid them.

Overview

1. Unclear financing purpose

A subordinated mortgage should always serve a clearly defined purpose, such as:

• Expanding an existing real estate portfolio through acquisitions
• Further development of a real estate project
• Investing in one's own business
• Renovating a property
• Bridging liquidity gaps

A common mistake is when borrowers use mezzanine capital without precise planning or clear goals. This can lead to inefficient use of additional funds or unexpected financial burdens.

Tip for borrowers: Create a detailed financing plan that outlines how and when the funds will be used. A clear purpose not only increases the success of your project but also strengthens your negotiating position with financing partners.

2. Lack of "exit strategies"

Closely linked to the financing plan is a solid strategy for repaying or replacing subordinated debt. An unclear or unrealistic exit scenario can become problematic when the financing term ends and no follow-up financing or repayment option is available.

Tip for borrowers: Develop a conservative financial forecast that accounts for pessimistic scenarios (e.g., decreasing property values or changing interest rates). Ensure that your repayment ability remains stable even in unforeseen circumstances. Create multiple exit strategies, such as selling or leveraging another property.

Additional insider tip for borrowers: Many borrowers primarily seek to increase their existing mortgage to gain additional liquidity, avoiding the need for a separate mezzanine exit strategy. However, banks often require extra time to assess whether an increase is possible, while borrowers may want to act quickly on attractive market opportunities. In such cases, mezzanine capital in the form of a bridge loan can be a useful interim solution until the mortgage increase is finalised.

3. Overly ambitious timelines

Another common mistake in subordinated real estate financing is unrealistic timelines – both for project execution and debt repayment. Financing partners such as banks and lenders, as well as potential buyers, need sufficient time to review a request (due diligence), draft tailored loan agreements, and approve financing through internal committees.

Tip for borrowers: Engage early with financing partners (or potential buyers) and inquire about the required documentation for their review process. Account for time buffers to proactively mitigate delays. Keep necessary documents up to date and readily available (ideally in a well-structured data room). Also, allow sufficient time for regulatory bodies and notaries, and discuss the transaction in advance with relevant parties. This also applies to mezzanine enquiries themselves. Place these at an early stage and not shortly before financing is required. Like banks, many providers of mezzanine loans have so-called KYC checks, which must be carried out for new customers and take a corresponding amount of time. An early enquiry can save a lot of time when it comes to the actual need for capital.

Additional insider tip for borrowers: Negotiate possible extension options in the loan agreement beforehand. While these may incur additional costs, they offer the flexibility to extend the loan if necessary and make repayment at a later date.

4. Neglecting regulatory frameworks and changes

In Switzerland, there are specific regulatory requirements for granting (subordinated) mortgages and leveraging properties. In our recent article on Basel III, we discussed the new Capital Adequacy Ordinance (ERV), which came into effect on January 1, 2025, extending the validity period of the lower value principle in mortgage lending. Failure to consider regulatory frameworks can negatively impact financial planning and lead to unforeseen consequences during debt repayment.

Tip for borrowers: Consult with industry experts to stay informed about current trends and developments. Engage with multiple banks to understand their lending criteria and regulatory responses. If necessary, work with a specialised financial or legal advisor to stay prepared for future regulatory requirements.

5. Lack of overview of the entire debt structure

Borrowers often focus only on the terms of their latest (subordinated) financing while losing track of their overall debt structure. This oversight can lead to two main issues:

• Failing to account for additional obligations in their overall financial situation
• Creating incomplete repayment and refinancing schedules (also linked to Point 3)

Tip for borrowers: Analyse your entire debt structure, including existing mortgages and other liabilities. Assess how the new financing will affect your total debt and liquidity. Based on this, develop an extended financial plan and corresponding repayment schedule.

Additional insider tip for borrowers: If you have already partially amortized your mortgage, consider reducing your debt certificate ("Schuldbrief"). Many borrowers assume that mezzanine lenders only look at the actual mortgage value. However, lending is based on the debt certificate amount. For example, if the first-lien debt certificate is CHF 12 million but the mortgage is only CHF 8 million, reducing the certificate to CHF 8 million is advisable. Otherwise, a subordinated mortgage cannot be established, and mezzanine financing is not possible until the certificate is adjusted. Maintaining a clear overview of the debt structure, including debt certificate amounts, is crucial.

Conclusion

Subordinated real estate financing offers numerous benefits for professional investors and borrowers but also presents significant challenges. The five most common mistakes outlined in this article highlight the importance of careful planning and expert guidance.

A well-defined financing plan, conservative exit strategies, realistic timelines, and a complete overview of the debt structure are essential for minimising risks and maximising financing success. Additionally, considering legal and regulatory requirements is crucial for ensuring long-term financial stability. By avoiding these mistakes, you lay a solid foundation for your financing and reduce risks.

Do you have questions about subordinated real estate financing? As an experienced Private Markets specialist focusing on subordinated mortgages, we are happy to help you develop a tailored solution.

Disclaimer
This commentary is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities or financial instruments. The information contained herein is not intended to provide investment, legal, or tax advice, and should not be relied upon in making any investment decisions. Investing in securities involves risks, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should carefully consider their own investment objectives, risk tolerance, and financial situation. The views and opinions expressed in this document are those of the author(s) and do not necessarily reflect the views of Artemon Capital Partners. Artemon Capital Partners does not guarantee the accuracy or completeness of the information provided herein, and disclaims any liability for any errors or omissions. Investors are advised to consult with their financial advisor or other qualified professionals before making any investment decisions.