Some people see mezzanine finance as a form of last resort lending, but this is wrong. Many of our clients choose to use mezzanine finance even though they are able to fund their developments themselves. The question is, why?
Mezzanine finance is used to fill the gap between a developer’s equity and the senior debt provided by a bank. In a typical case, a developer will put up equity of around 10% of cost, the bank will lend between 60% and 80% and the mezzanine lender can make up the difference. The mezzanine is provided as part of the equity required by the bank on day one, with the bank funding the building and professional costs plus part of the land acquisition costs.
Contrary to what you may think, mezzanine funding is rarely used because a developer is short of funds. In most cases, our clients choose to use mezzanine funding even though they have the necessary cash available. Here are six reasons why:
1. To increase the internal rate of return (IRR)
By using mezzanine finance a developer can significantly increase the IRR on his investment. This is best illustrated by an example:
Typical 18-month development cycle
|With mezzanine (£’000)||Without mezzanine (£’000)|
|Gross development value (net) (GDV)||5,000||5,000|
|Gross development cost (including bank loan) (GDC)||4,000||4,000|
|Profit on cost||25%||25%|
|Profit on sales||20%||20%|
|Total bank and mezzanine funding||3,500||2,750|
and exit fee
|Net profit to developer||773||1,000|
|Developer’s annualised return on equity||103%||53%|
As you can see, by using mezzanine finance the developer has been required to put in only £500,000 of his own money, compared to the £1.25m he would have had to put in without it. Not only has he almost doubled the return on his investment, (an IRR of 103% compared to an IRR of 53%), he has freed up £750,000 of equity to use on other projects.
2. It offers more control
Developers will often bring on board equity partners to help fund their schemes. This can lead to a host of issues not least of which is a lack of control. In our experience, equity partners nearly always want a say on how a development is run, and this can cause stress, conflict and even delay. In addition, equity investment can be expensive.
Many developers see mezzanine funding as “cheap” (and stress-free) equity. In most situations, more than 75% of the profit will accrue to the developer with the balance going towards the cost of the mezzanine finance.
3. Much of the cost is a charge on profits
The bulk of the cost of the mezzanine finance is payable as an exit fee on redemption of the loan. This means most of the cost of finance is a charge against profits earned rather than an additional working capital requirement.
4. It’s a highly flexible and simple source of funds
Mezzanine funding is by its very nature flexible. Every project we work on is different and we make sure we put in place a funding package that works for both the developer and the senior lender. For example, in some instances we will accept alternative security in place of the normal 10% cash commitment from the developer.
In addition, we will rely on the same valuation and quantity surveyor’s report prepared for the bank rather than our own advisors. This is not always the case with equity investors.
We also have an extremely rapid turnaround on decision making and the provision of funds. This ensures a smooth interaction between us, the bank and our respective solicitors (and, in fact, many of our clients are referred to us by banks).
5. It can get deals over the line
It would be wrong to suggest mezzanine finance is never used to get deals over the line. Bank lending to the property sector has reduced dramatically in recent years with mezzanine funding doing much to fill the lending gap. Many successful developers and profitable projects have made use of our mezzanine support to overcome the lending shortfall, but then continue to use our product on future deals.
6. Mezzanine lenders offer strategic assistance
Our business is to analyse each prospective project on the basis of its financial, marketing and construction viability to see if it fits within our lending criteria. This analysis includes the project timeframe, past experience of the developer and the availability of senior debt finance from a bank. This gives us huge knowledge and experience and we share this with our clients where it can help the success of a project.
To discuss using mezzanine finance on your next development project, call us now.