Securing mezzanine finance
Although significantly more expensive than the cost of senior debt, mezzanine finance enables a developer to proceed with a project which would be otherwise unaffordable.
Mezzanine finance is more expensive than bank debt but cheaper than equity, it is often used as an alternative to high yield bonds. It is usually used as a top up to a first or second charge on a bridging loan for property development.
Rob Jupp, Managing Director of Brightstar Financial Limited, spoke of the main advantages of using mezzanine: “It allows developers to seek higher layer debt that they wouldn’t be able to access by senior debt funding.”
Criag Scott, Director at Commercial 1 Limited, said: “The advantage of Mezzanine funding is having the ability to provide funding sources to your clients for the gap between senior debt and equity.”
Areas where Mezzanine is used would be Development funding, step in finance, Refinancing maturing loans, Acquisition finance.”
When a bank deems something a high risk case, the next option many feel they have to pursue is private equity investors but that means you will be in a situation of losing equity.
Mezzanine finance is able to produce results on occasions where a traditional loan is deemed too risky or where an existing bridging loan will not cover an unsuspected spike in cost or a developer sees an opportunity to add value to a development and would require extra investment.
Rob Jupp also described how this can happen and how Mezzanine finance could become the only option for a developer: “Developers very often, through no fault of their own, miscalculate their extent of finance.
“It might be that they’ve got some construction issues they didn’t foresee. It might be that they need to make some market improvement to their plans, to take advantage of changes to social and economic demographics and they just need more money to finish it.
“There are always significant profits if a development scheme is done well by completion of project. It is important that the project gets completed on schedule and then the developer can get his or her profit out.”
Craig Scott spoke of how his company finds mezzanine finance a useful source of business and outlined examples of its use and the advantages it led to: “At Commercial 1 Mezzanine funding is a core part of our offering to our clients so we would have many examples.
“One example we have currently is with an experienced developer of ours to which we have enjoyed a business relationship with for over 5 years; he was offered a site in the south east which represented a very attractive profit return to build out a five bedroom 4,500 sq ft property in a private road.
“We had agreed the senior debt but he was short by 25% of his cash stake to put in to the purchase. He has three properties in his portfolio which he developed and completed 2 years ago, the timing was not right to market in 2009 hence letting them out but now on the advice of his agents was the right to place them on the market,” he added.
“Since placing the properties on the market, two are now under offer so the exit for the Mezzanine coupled with a percentage of senior debt is guaranteed. However, without the assistance of mezzanine funding my client would have lost out on this excellent business opportunity as he would not have had the full amount to put into the purchase.”
The nature of mezzanine finance provides certain risks for a lender, which goes some way to explain the high rates attached to this kind of loan.
Jonathan Newman, Senior Partner at Brightstone Law LLP, spoke of how the factors that can attract lenders can also be a reason not to take on a Mezzanine finance loan book.
“A mezzanine finance lender, traditionally, would be taking a greater level of risk. Their portion of the overall finance would be at the higher LTV. Effectively the first tier finance is taken out first and the mezzanine lender would be on a lower priority – it will lose money if the debt faults,” he said.
“They get a very good return for that. They get the higher interest rate because they are more likely to lose capital and interest if the property doesn’t realise sufficient to repay the facility in full.”
The relationship between the initial lender and the lender offering the mezzanine loan is also essential in being able to secure the finance. Brokers must be aware that the existing loan on the development will have a significant bearing on the success of an application for a top-up.
Jonathan Newman continued: “The terms of the security are defined by the agreement between the first tier lender and the mezzanine financier and, more often than not, the first tier finance takes his money, capital, interest costs and expenses and that’s where the risk is.
“Also, they rely heavily, or take great comfort in the success of, the primary lender. So the mezzanine financier is keen upon the first tier lender having a good success rate and so is placing its money on a particular loan.”
Brokers must also be aware of certain pitfalls surrounding this area of lending and a sound valuation of the development will bear heavily on the risk attached to this kind of finance.
Craig Scott said: “As with any degree of short term funding the key to success is a water tight exit with all parties’ loans being repaid on time avoiding unnecessary penalties with the client maintaining the profit margins they set out to achieve from the start of the project.”
Jonathan Newman added: “A typical pitfall is a valuation issue – if the property doesn’t stand up to valuation then they are more likely to lose capital and interest.”
It is this risk and complexity that makes mezzanine finance something of a niche area and not as widely available as most other development finance. The nature of this area means that an experienced lender or distributor is essential for securing the finance needed.
Craig Scott described what brokers needed to do when seeking this kind of funding:
”When dealing with Mezzanine funders brokers need to have a complete understanding of how Mezzanine funding works and how this can be delivered back to their client alongside how the Mezzanine funder works in conjunction with the Senior debt provider.”
Rob Jupp intimates the need for a broker to seek guidance at as early a stage as possible: “Brokers need not bring anything to the table and should try not to do this themselves. It’s a very specialised area.
“My advice to brokers would be to seek the guidance of those in the market with good experience in the area of mezzanine finance. They really need to speak to specialists.”
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