The intercreditor purchase option lets the mezzanine lender take control, but the price is set by the senior claim, not by the building.
A mezzanine lender should exercise its option to buy a defaulted senior loan only if the new money it puts in earns its required return on the business plan; what is left over is all the old mezzanine position recovers. On an illustrative $60.0m senior loan bought for $62.50m, a two-year recovery plan returns 12.4 per cent on the new money and recovers only 2.9 cents on the $15.825m mezzanine claim; at a 6.0 per cent exit yield instead of 6.5, it recovers 34.7 cents.
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 purchase option is the mezzanine lender's main protection in a standard intercreditor agreement. Once the senior loan is in default, or accelerated, the mezzanine lender may buy it at a defined price and take control of enforcement, rather than watch the senior lender sell the property at a price that wipes it out. The option is valuable. It is also expensive, because the price is set by the senior claim, not by the value of the building. Its cheaper sibling, curing the borrower's missed payments, keeps the senior loan in place; buying it out is the tool for when the senior loan has been accelerated or the cure rights are exhausted.
| Input | Value |
|---|---|
| Senior loan, interest-only at 6.0% | 60.0 |
| Unpaid senior interest | 6 months |
| Senior protective advances / enforcement costs to date | 0.5 / 0.2 |
| Senior default margin / exit fee | 4.0% / 1.0% |
| Mezzanine loan at 11.0%, six months unpaid | 15.0 |
| As-is market value / forced sale value in a senior enforcement | 62.0 / 55.0 |
| UCC foreclosure on the pledged equity, cost | 0.4 |
| Recovery plan: capex and leasing in year 1 | 4.0 |
| NOI year 1 / year 2 / forward NOI at sale | 3.2 / 4.6 / 5.0 |
| Exit yield / sale costs / required return on new money | 6.5% / 1.5% / 12% |
Intercreditor agreements usually set the price at par plus accrued interest at the non-default rate, protective advances and the senior lender's enforcement costs. Whether default interest, late charges and exit or prepayment fees are added is negotiated, and it matters.
Accrued interest = 60.0 × 6.0% × 6 ÷ 12 = 1.80
Purchase price = 60.0 + 1.80 + 0.5 + 0.2 = 62.50
Excluded here: default interest 60.0 × 4.0% × 6 ÷ 12 = 1.20, and the exit fee 0.60. Included, the price would be 64.30.
The price is 0.50 above the as-is value of the building. Buying the senior loan and selling the property straight away would return 61.07 after sale costs for an outlay of 62.90 including the foreclosure on the pledged equity: a loss of 1.83. The option only has value if the mezzanine lender can do something with the building that the senior lender will not.
If the senior lender enforces, it sells at the forced value of 55.0 against a claim of 62.50 and is itself short by 7.5. The mezzanine lender, behind it, recovers nothing on its 15.825 claim: 15.0 of principal and 0.825 of unpaid interest. Zero is the benchmark the buyout is compared with.
Year 0: purchase price and UCC foreclosure = −62.50 − 0.4 = −62.90
Year 1: NOI less capex = 3.2 − 4.0 = −0.80
Year 2: NOI + net sale = 4.6 + 5.0 ÷ 6.5% × (1 − 1.5%) = 4.6 + 76.92 × 98.5% = 4.6 + 75.77 = 80.37
IRR on the new money = 12.4%; 63.70 in, 80.37 back, a 1.26x multiple
NPV at 12% = 0.46, which is what the old mezzanine claim is worth: 0.46 ÷ 15.825 = 2.9 cents
Excel: =IRR(Flows) and =NPV(12%,Y1:Y2)+Y0
This is the honest way to value the option. The 62.90 put in today is new capital and has to earn what new capital earns. Only the surplus above that return belongs to the old position. Counting the 16.67 of profit on the buyout as recovery of the mezzanine loan treats fresh money as free.
| Exit yield | Exit value | IRR on new money | NPV at 12% | Old claim recovered, cents |
|---|---|---|---|---|
| 6.0% | 83.33 | 16.8% | 5.49 | 34.7 |
| 6.5% | 76.92 | 12.4% | 0.46 | 2.9 |
| 7.0% | 71.43 | 8.5% | −3.86 | 0.0 |
| 7.5% | 66.67 | 5.1% | −7.60 | 0.0 |
The break-even exit value for a 12 per cent return is 76.34, a 6.55 per cent exit yield. Below it, buying the senior loan destroys value, even though the new money is returned in nominal terms at any exit value above 60.00, an 8.33 per cent yield. Between those two lines the buyout looks like a recovery and is in fact a below-market investment.
The price terms move the answer as much as the market. If the intercreditor lets the senior lender add default interest and the exit fee, the price is 64.30, the IRR falls to 10.8 per cent and the NPV to −1.34: the option is worthless in the base case.
Value the purchase option as a new investment: price = senior par + non-default interest + advances + costs; old claim recovery = NPV of the plan at the required return on new money. Here that is 2.9 cents in the base case and 34.7 cents if the exit yield is half a point better. Where the mezzanine slice sits in the stack is in attachment and detachment points, and the enforcement route itself in share pledge vs mortgage enforcement. The book's sizing and exit-test model is in the free workbook for this case.
Usually the senior loan's outstanding principal, accrued interest at the non-default rate, protective advances and the senior lender's enforcement costs. Default interest, late charges and exit fees are negotiated. In the illustrative case the price is 62.50 million on a 60.0 million loan; adding default interest of 1.20 million and a 0.60 million exit fee takes it to 64.30 million.
When the building, run to the mezzanine lender's plan, is worth more than the purchase price plus plan costs at the return new capital requires. In the illustrative case that needs an exit value above 76.34 million, a 6.55 per cent exit yield on 5.0 million of forward NOI, for a 12 per cent return on the 62.90 million put in.
Often nothing. If the senior lender enforces and sells at a forced value of 55.0 million against a 62.50 million claim, the senior lender is itself 7.5 million short, and the mezzanine claim of 15.825 million recovers zero. That is the benchmark against which the buyout is measured.
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.
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