An income producing commercial property is being financed based on the following assumptions.

Acquisition Price 15 Euro Million

Net Operating Income 0.8 Euro Million
Annual increae in NOI 3%
Annual increase in property va 3%
It is assumed that the property's lease contract will end after 6 years and it will also be sold by the end of 6th year. The proposed capital
structure & financing cost are follows:
Capital Structure
Loan to Payment Equity-
Value Cash in Kind Kicker
(LTV) Interest (PIK) (EK)
Senior Debt 65% 5%
Mezzanine 20% 5% 3% 50%
The mezzanine debt terms incorporate cash interest component of 5%, PIK interest of 3% and an equity kicker paid at the end & calculated
as follows:
Mezzanine debt x [50% x excess IRR of operating cashflows over IRR of senior debt x 6 years]

Q. Estimate the Cash Flows, Cash on Cash Return & IRR of Senior debt holders, Mezzanine debt holders & Equity holders.

Soln
Euro million 0 1 2 3 4 5 6 COC IRR
Property
NOI 0.80 0.82 0.85 0.87 0.90 0.93
Investment -15 17.91
Net Cash Flow (15.00) 0.80 0.82 0.85 0.87 0.90 18.84 1.54 8.33%

Senior Debt
Principal (9.75) 9.75
Interest 0.49 0.49 0.49 0.49 0.49 0.49
Cashflow to Senior Debt (9.75) 0.49 0.49 0.49 0.49 0.49 10.24 1.30 5.00%

Mezzanine Debt
Accreted Value
Beginning value 3.00 3.00 3.09 3.18 3.28 3.38 3.48
Accrued PIK interest 0.09 0.09 0.10 0.10 0.10 0.10
End value 3.00 3.09 3.18 3.28 3.38 3.48 3.58
Cashflows
Principal (3.00) 3.00
Cash Interest 0.15 0.15 0.16 0.16 0.17 0.17
PIK Interest 0.58
Equity Kicker 0.30
Cashflows to Mezzanine (3.00) 0.15 0.15 0.16 0.16 0.17 4.06 1.62 9.23%

Cashflows to Equity (2.25) 0.16 0.18 0.20 0.22 0.24 4.54 2.47 18.47%

Without Mezzanine Finance

Senior Debt LTV 70%
Senior Debt
Principal (10.50) 10.50
Interest 0.53 0.53 0.53 0.53 0.53 0.53
Cashflow to Senior Debt (10.50) 0.53 0.53 0.53 0.53 0.53 11.03 1.30 5.00%

Cashflows to Equity (4.50) 0.28 0.30 0.32 0.35 0.38 7.81 2.10 14.72%

IRR to equity is increasing by adding mezzanine bcoz

mezzanine allows you to take more leverage
since you get more leverage your actual returns turn out to be high