Mezzanine Finance:

Real Estate Loan Concepts andSecurity and Intercreditor Issues

Mezzanine Finance

I. Basic Structure – What is Mezzanine Finance?

A mezzanine loan is a loan by a Mezzanine Lender to the corporate entity which owns the Mortgage Borrower

Mezzanine Finance

I. Basic Structure – What is Mezzanine Finance?

Typically, an LLC - Even if the Mortgage Borrower has a number of investors, typically a Mezzanine Lender will require the Mortgage Borrower to be dropped into to a single purpose single member entity, preferably a Delaware limited liability company which itself will be owned by a single purpose single member limited liability company.

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Basic Structure – What is Mezzanine Finance?

Mezzanine Finance

I. Basic Structure – What is Mezzanine Finance?

Collateral - (i) a lien on any distributions by the Mortgage Borrower to the Mezzanine Borrower and (ii) a security interest in and pledge of the Mezzanine Borrower’s ownership interest in the Mortgage Borrower, including voting rights, which translates into the value of the real property above the amount of the mortgage loan commonly known as the “equity.”

Mezzanine Finance

I. Basic Structure – What is Mezzanine Finance?

Known as a “Soft Loan” - has no direct pledge of the mortgaged property, a “hard” asset, but instead has a pledge of the ownership interests in the Mortgage Borrower, a “soft” asset, the loan is typically categorized as a “soft” money loan. The right to cash flow from the Mezzanine Borrower not the ability to own or control the “hard” asset is the source of repayment.

Mezzanine Finance

II. Loan Documents

A. The Loan Agreement

1. Loan Terms. Agreement will set amount, interest rate, maturity date, and prepayment rights. In most cases a separate promissory note is also used to evidence the amount of the loan but the material terms will be contained within the Mezzanine Loan Agreement. In many instances the Mezzanine Loan Agreement is duplicated from the Mortgage Loan Agreement unless the parties have opted for specific forms like a combined mortgage and mezzanine loan structure from one lender.

Mezzanine Finance

II. Loan Documents

A. The Loan Agreement (Cont’d)

2. Covenants. The Mezzanine Loan Agreement will also contain mortgage borrower level covenants typically found in mortgages. These covenants will be documented as prohibitions against and requirements by Mezzanine Borrower to cause or prevent specific actsas the owner of Mortgage Borrower, respectively.

Mezzanine Finance

II. Loan Documents

A. The Loan Agreement (Cont’d)

The following are typical mezzanine covenants:

i. Prohibition on additional indebtedness;

ii. Requirement to make distribution of excess cash flow in accordance with the Mezzanine Loan Agreement;

iii. Requirement to comply with standard property level operational covenants; and

iv. Requirement to enter into and comply with cash management with respect to excess proceeds and in particular providing for all excess cash flow after payment of debt service and operating expenses to go to a Mezzanine Lender controlled lockbox;

Mezzanine Finance

II. Loan Documents

B. The Pledge and Security Agreement

1. An agreement by Mezzanine Borrower in favor of Mezzanine Lender where the Mezzanine Borrower pledges (the “Pledge”) its ownership interests (typically 100%) in the Mortgage Borrower (the “Collateral”) to Mezzanine Lender.

Mezzanine Finance

II. Loan Documents

B. The Pledge and Security Agreement (cont’d)

2. Opt in to Art. 8 – Typically, a requirement to Opt into Article 8 and require Mezzanine Borrower to issue “physical” securities in the membership interests in Mortgage Borrower so Mezzanine Lender may perfect by possession (Opt-in language included).

Mezzanine Finance

II. Loan Documents

B. The Pledge and Security Agreement (cont’d)

3. Control Agreement (form included) – a separate control agreement can be added along with a proxy/stock power and an irrevocable proxy (form included). This is particularly important for Delaware entities since Delaware law does not include voting rights and control for the purpose of pledged interests unless clearly specified.

Mezzanine Finance

II. Loan Documents

C. Environmental Indemnity Agreement

1. In many cases the Guarantors for the Mezzanine Loan and the Mortgage Loan are the same. As a result, the Mortgage Lender will typically require the Mezzanine Lender to subordinate any claims against the Guarantors under the Environmental Indemnity to its claims until such time as the Mortgage Lender has been paid off.

Mezzanine Finance

II. Loan Documents

D. Deposit Account Control Agreement (“DACA”)

1. Only necessary where Mezzanine Lender has set up reserves at the Mezzanine Loan level. Typically, where “hard” money management is used at the Mortgage Loan level Mezzanine Lender will negotiate a “bucket” for mezzanine loan debt service to be paid out of the “waterfall” with excess going to the Mezzanine Borrower.

Mezzanine Finance

II. Loan Documents

D. Deposit Account Control Agreement (“DACA”)

2. There also instances where DACA can spring into effect in the event that “hard” or “soft” money management is no longer maintained at the Mortgage Level.

Mezzanine Finance

III. Title Insurance/UCC Policy

A. UCC-9 Policy (form included)

1. Mezzanine loan version of title insurance

2. Insures first priority security interest in mezzanine collateral

3. Insurance Provider will perform due diligence:

a. UCC searchesb. Review of loan documents and organizational documentsc. Confirm no other membership interest certificates outstandingd. Confirm lender’s possession of membership interest certificate

4. Endorsements are available to delete certain standard exclusions from coverage

5. Should have UCC-9 insurer sign an escrow instruction letter similar to that signed by the title company

Mezzanine Finance

III. Title Insurance/UCC Policy

B. Mezzanine Endorsement (form included)

1. Endorsement to Owner’s (not Lender’s) title insurance policy

2. Provides for the following:

a. assignment to Mezzanine Lender of the Owner’s right to receive title insurance proceeds, up to an amount of outstanding mezzanine indebtedness

b. no amendments to the Owner’s Policy are permitted without the Mezzanine Lender’s consent

c. additional coverage for certain exclusions from coverage that apply to the Owner, including non-imputation

d. agreement by title company not to deny liability on the ground that ownership interests in the Owner have been transferred to the Mezzanine Lender

3. Requires execution by Mezzanine Lender

Mezzanine Finance

IV. Perfection of Security Interest

A. In general, there are two (2) typical methods of perfecting a security interest:

1. Perfection by Filing: Filing a UCC-1 Financing Statement under Article 9 of the UCC

2. Perfection by Possession and Control of the Collateral

Mezzanine Finance

IV. Perfection of Security InterestB. In Mezzanine Financing, since the collateral consists of a “general intangible” under the UCC, there are two (2) ways to perfect a security interest in the Mezzanine Collateral.

1. Method 1 : Filing under Article 9 of the UCC as “Investment Property” within the meaning of §9-102 together with rights to proceeds, distributions, etc. It requires the LLC agreement of Mortgage Borrower to absolutely prohibit the issuance of physical interests since physical possession under Article 8 takes priority over perfection by filing under Article 9.

Mezzanine Finance

IV. Perfection of Security Interest

2. Method 2: Opting into Article 8 of the UCCand perfecting by taking possession of the Collateral as a “Security” within the meaning of §8-102.

In Mezzanine Financing, we perfect our security interest using both methods in order to ensure “protected purchaser” status under the UCC.

Mezzanine Finance

V. Intercreditor Agreement

A. Parties – Mortgage Lender and Mezzanine Lender (not Borrower)

B. Purpose – “provide for the relative priority” and “evidence certain agreements”

C. Basic Structure of Agreement

Mezzanine Finance

V. Intercreditor Agreement (Cont’d)

C. Basic Structure of Agreement

1. Reps and warranties2. Transfer provisions3. Foreclosure of mezzanine collateral4. Loan modifications5. Subordination provisions; bankruptcy rights6. Cure rights and purchase rights7. Other agreements

Mezzanine Finance

VI. Enforcement

A. Special attention must be paid to the IntercreditorAgreement

B. Key Considerations:

1. Is Mortgage Lender consent required to transfer the Mezzanine Loan or any interest therein?

2. Is a Replacement guarantor required?3. Who has the ability to exercise cure / purchase rights?4. Does any modification of the Mezzanine Loan

Documents require consent of the Mortgage Lender?

Mezzanine Finance

VI. Enforcement

B. Exercise of Remedies

1. Loan Workout

2. Assignment in lieu / strict foreclosure

3. UCC Sale

4. Bankruptcy issues

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