Mezzanine funding is often misunderstood. 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.
Below are some of the frequently asked questions we receive in relation to mezzanine funding.
Is mezzanine funding a form of last resort finance like bridging finance?
No. 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 around 60% of cost and the mezzanine lender will 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.
How does using mezzanine finance increase a developer’s 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:
|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||3,600||2,400|
|MEZZANINE INTEREST AND EXIT FEE||315||0|
|NET PROFIT TO DEVELOPER||685||1,000|
|DEVELOPER'S RETURN ON EQUITY||171%||63%|
As you can see, by using mezzanine finance the developer has been required to put in only £400,000 of his own money, compared to the £1,600,000 he would have had to put in without it. Not only he has he more than doubled the return on his investment, (171% compared to 63%), he has freed up £1,200,000 to use on other projects.
Wouldn’t a developer be better off finding an equity investor?
Not necessarily. Bringing on board equity partners to help fund a scheme can lead to a host of issues for a developer 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, causing stress, conflict and delay.
In addition, equity investment can be expensive. Many developers see mezzanine funding as “cheap” (and stress-free) equity. In most mezzanine situations, more than 80% of the profit will accrue to the developer, with the balance going towards the cost of the mezzanine finance.
Will taking out mezzanine finance increase the working capital requirements for a development?
No. 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.
Will taking out mezzanine finance be a lengthy and time-consuming process, and involve more legal work and a new valuation?
No. We 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. In fact, many of our clients are referred to us by banks.
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.
Also, when we make a mezzanine loan, we rely on the same valuation and quantity surveyor’s reports prepared for the bank rather than use our own advisors. This is not always the case with equity investors.
For more information about how mezzanine finance can help property developers, please download our white paper.