The first thing I recommend is that if you are not comfortable taking ownership of the property, you should find someone who is. Your best protection is having a complete understanding of the property and not being afraid to enforce when necessary. While there are some protections to negotiate for, focus on the intercreditor agreement and creating a relationship with the senior lender. During any period of default, you will not receive any returns. Negotiate for consent rights, cure rights and the right to buy out the senior lender. The most important thing is to underwrite the loan, leaving enough cushion in case there is a problem.
How can a mezzanine lender mitigate risk?
We are exploring the possibility of providing mezzanine debt because of the relatively high return. Obviously, the return is high because of the risk of being behind the senior debt. Are there any ways to mitigate some of the risk?
Anything below may be subject to the inter-creditor agreement between the secured lender and the mezzanine lender. Possible enhancements may include: security interests in property not secured to the secured lender; third-party guarantees; letters of credit; and covenants, the violation of which will provide relief to the mezzanine lender. The above does not constitute legal advice, as the actual facts and circumstances have not been made available to us.
Make a small investment in equity into the JV or GP/LP with rights to seize control in the event of default.
There are a number of ways mezzanine lenders will employ to mitigate risk, such as to ensure they have strong loan documents that provide them with good remedies (for which you would need experienced counsel) and be pretty certain about your underwriting. However, most senior lenders will not grant mezzanine lenders much protection in the intercreditor agreements in the event of defaults under both senior and mezzanine loans. This is beyond notice and cure by the mezzanine lender for monetary defaults and the right to pay off the senior loan prior to foreclosure. So, if the senior loan is in default, particularly if it is a maturity default, you would need to be prepared to write a payoff to the senior loan to protect your investment, unless the senior lender would agree to do a restructuring or extension of its loan with either the borrower or with you succeeding to the borrower's interests. This is only something that can be determined at the time of the default, and the senior lender will act in its best interests at that time, whatever that may be.