Cure rights in an intercreditor agreement are an option with a premium paid monthly. Price the premium against the equity it lets the mezzanine lender keep.
A mezzanine lender should cure a senior loan default when the equity it can take over is worth more, in present value, than the cash the cure costs: the arrears, the monthly shortfall until it can sell, and its own foreclosure costs. On an illustrative $66.0m property with a $56.0m senior loan in default, curing costs $2.12m in present value and recovers a net $5.09m, 53.8 cents on a $9.45m claim, against nothing if the senior lender enforces. The cure pays as long as the property sells for more than $60.15m, 8.9 per cent below today's value.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A mezzanine loan is secured on the shares of the company that owns the property, not on the property itself. When the senior mortgage defaults, the senior lender can enforce on the building and leave the mezzanine lender with shares in an empty company. The intercreditor agreement usually gives the mezzanine lender two tools to prevent that: the right to cure the borrower's monetary defaults, typically a limited number of times, while it forecloses on the pledged equity, and an option to buy the senior loan, usually at par plus accrued interest and costs. This article prices the first; the second is priced in when a mezzanine lender should buy the senior loan.
| Input | Value |
|---|---|
| Property value today, as is | $66.0m |
| Senior loan, interest only at 6.5% | $56.0m |
| Net operating income, current | $2.4m a year |
| Senior payments missed / late charge / senior's legal costs | 2 / 5% / $75,000 |
| Mezzanine principal plus accrued interest | $9.0m + $0.45m = $9.45m |
| Equity (UCC) foreclosure: month / cost | 3 / $250,000 |
| Sale of the property: month / selling costs / senior prepayment fee | 12 / 2% / 1% |
| Mezzanine lender's required return | 12% |
| If not cured: senior forced sale at / enforcement costs | 85% of value / $1.5m |
The senior loan sits at 84.8 per cent of value and the mezzanine takes the stack to 98.5 per cent. Debt service is $303,333 a month against $200,000 of income, a DSCR of 0.66: the owner has stopped paying because the building no longer carries its debt.
Arrears = 2 × $303,333 = $606,667; late charges at 5% = $30,333; senior legal costs $75,000
Initial cure = $712,000
Monthly shortfall = $303,333 − $200,000 = $103,333, for 12 months until the sale, assuming the property's income keeps going to senior debt service through the senior loan's cash management account: $1,240,000, or $1,163,025 in present value at 1 per cent a month
Equity foreclosure costs in month 3: $250,000, PV $242,648
Total cost of curing = $712,000 + $1,163,025 + $242,648 = $2,117,672 in present value
After the equity foreclosure it owns the borrower and sells in month 12:
Net to equity = $66.0m × 98% − $56.0m × 1.01 = $64.68m − $56.56m = $8,120,000, worth $7,206,088 today
NPV of curing = $7,206,088 − $2,117,672 = $5,088,415
Break-even sale price = (PV of cure costs ÷ discount factor + senior payoff) ÷ (1 − selling costs)
= ($2,117,672 ÷ 0.8874 + $56.56m) ÷ 98% = $60.15m
In Excel: =(CurePV/(1+12%/12)^-12+Senior*(1+Prepay))/(1-SellCosts)
If the mezzanine lender does nothing, the senior lender enforces, sells at an illustrative 85 per cent of value, $56.1m, and after $1.5m of enforcement costs and the arrears there is a deficit of $2,037,000 on the senior loan itself. The equity, which is the mezzanine lender's collateral, is worth nothing. Curing turns a likely zero into 53.8 cents on the dollar, and every dollar spent on the cure comes back 3.7 times if the building sells at today's value.
The cure works because it buys time and avoids the forced sale. The illustrative 15 per cent discount of a lender's forced sale is larger than the whole mezzanine position; the cure money keeps the building out of that discount long enough for the mezzanine lender to become the owner and sell it properly. The arithmetic of where a junior slice attaches and detaches is in how mezzanine attachment and detachment points are calculated.
| Sale price | Month 6 | Month 12 | Month 24 |
|---|---|---|---|
| $58m | −1.29 | −1.87 | −2.93 |
| $60m | 0.56 | −0.13 | −1.39 |
| $62m | 2.40 | 1.61 | 0.16 |
| $66m | 6.10 | 5.09 | 3.25 |
| $70m | 9.79 | 8.57 | 6.33 |
Time matters because the shortfall is paid every month and the equity is discounted for every month it waits. At $60m the cure pays if the building sells within six months and fails if it takes a year. Weaker income raises the bar: at $1.2m of NOI the monthly shortfall nearly doubles to $203,333 and the break-even price rises to $61.44m; if income covered debt service in full, the cure would cost only the arrears and the foreclosure, and break-even would fall to $58.81m, still above the $56.56m needed to repay the senior loan.
Comparing the cure money with the size of the mezzanine claim. The $9.45m claim is sunk either way: without a cure it is worth nothing, so the question is only whether $2.12m of new money buys more than $2.12m of value. The opposite mistake is curing out of reflex without a view on value. Each cure is limited in number and must be paid in full; a mezzanine lender that cures for a year and then finds the building worth $58m has lost most of the cure money on top of the loan. Measure the distance between today's value and the break-even, as how far value can fall before a lender loses does for a senior loan, and cure only if the cushion survives a realistic downside.
Price the cure as an investment: arrears plus the monthly shortfall plus foreclosure costs, against the equity you will own when the building sells. Here $2.12m buys $7.21m, and the decision holds down to a sale at $60.15m. The capital stack and the junior loan's recovery at each value are built in the free workbooks for Real Estate Finance.
Under a typical intercreditor agreement the mezzanine lender may cure the borrower's defaults on the senior loan, usually monetary ones and a limited number of times, so that the senior lender does not accelerate while the mezzanine lender forecloses on the pledged equity. In the illustrative case the first cure costs $712,000 of arrears, late charges and senior legal costs, then $103,333 a month.
The mezzanine loan is secured on the shares of the owner, so a senior foreclosure takes the building and usually leaves the shares worthless. In the illustrative case a forced sale at 85 per cent of a $66.0m value, after $1.5m of enforcement costs and the arrears, leaves a $2,037,000 deficit on the senior loan, and the mezzanine lender recovers nothing.
As long as the equity it will own is worth more than the cash still to be spent. Illustratively, at a $60m sale price curing is worth $0.56m if the building sells in month 6 and minus $0.13m if it takes until month 12; at $62m it still pays at month 24, by $0.16m.
This article is one calculation from Real Estate Finance. 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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