Mezzanine Finance

Traditionally development projects have been funded almost exclusively by banks, with more recent non-bank participants entering the market. The amount of funding is typically determined by a percentage of the actual costs of the development. The amount of funding the banks will offer ranges from 50%-80% of the hard costs of the project, limited by location, type of project, amount of pre-sales, etc. This type of funding is typically referred to as Senior debt.

If a property developer wanted additional finance beyond what the banks were willing to lend on the project the developers options are as follows:

Provide additional security In the past when a developer wanted to borrow more than the bank was willing to lend for a project, additional security would be required, which the bank would cross-collateralise against the project. This would in effect mean that the bank would place a mortgage on the developers other assets and lock them in for one project. More importantly the developer would not be able to use his assets to raise equity to capitalise on any other opportunities until this project was completed.
Equity Partners (Joint Venture) This is where the developer seeks partners to invest in the project. The advantages for the developer is that the project risk is shared among the partnership, however so are the profits. This is the most appropriate way of raising funds in the early stages of a proposed development, before approvals, etc. At the early stages the risks and returns are at their greatest, and all parties involved realise if the proposed development is approved and completed there will be substantial profits, however if the project is not approved or completed there may be losses incurred.
Mezzanine Finance Property developers have always been looking for more innovative ways of funding their projects and one such way is Mezzanine Finance. Mezzanine Finance is a form of subordinated debt behind that of senior debt in terms of ranking on any claim on property assets and ahead of equity. Mezzanine Finance is generally secured by a second mortgage, and a second ranked fixed and floating charge over the borrowing entity and its directors. In short Mezzanine Finance fills the gap between the property developers equity and the amount of senior debt available. Mezzanine Finance is only provided when the project is ready to begin, and the relevant risk mitigants are in place.

Diagrammatically, project risk can be illustrated as follows:

General Project Time Line:

Land is identified
Development Plan and Marketing Plan is conceptualised
Land is secured (either purchased or optioned)
Development proposal is prepared (architectural plans etc)
Development proposal is submitted to relevant authority
Marketing Plan is initiated (i.e. presales begin)
Development is approved
Development finance is put in place
Construction commences
Construction Completed
Development is sold

As per the above timeline Mezzanine Finance will only be available to a development from stage 7. As such there is an identifiable project ready to commence, with the relevant independent feasibility study and risk mitigants such as presales in place.

Mezzanine Finance is more expensive than Senior Debt. The interest rates vary in line with the risk of the project. The funds are provided at the beginning of the construction of the project (step 8-9 in the above timeline), which attract an interest rate, which is compounded and paid at the end of the project. Whilst the cost of Mezzanine Finance may seem expensive, when considering the overall cost of funds, or the blended rate, the overall financing costs are not significantly increased.

Experienced and financially savvy developers are interested in Mezzanine Finance as it provides the following benefits:

It gives the developer the power to determine the level of equity (if any) he wishes to contribute to a project
It is cheaper than equity, and provides a higher project rate of return on their equity
It allows the property developer to use his equity elsewhere and effectively diversifying risk
It allows the property developer to continue with the project on a ‘stand alone’ basis
Control is retained by the property developer as opposed to Joint Venture partners
Mezzanine Finance is passive provided the project is performing
Interest is tax deductible, profits are not
It can be raised relatively quickly as opposed to equity
It will normally reduce the risk to the Senior Debt provider, and should lead to a lower rate

Lets have a look at a simple example to see the benefits to the developer.

Assumptions (all figure exclude GST);
Gross Realisable Value:

Land Cost/Value:

Construction Costs:

Total Costs (excl interest and GST):

Construction Period:

GCC Cost Based Facility Interest Rate:

GCC GRVBased Facility Interest Rate:

$13,000,000

$5,000,000

$10,000,000
12 months

8% pa
11% pa

Please note that rates and figures used are for illustrative purposes only, and any actual transaction will be priced according to the specifics of the project.

Project Structure Comparison

	Traditional Cost Based facility	Structured Senior & Mez Debt
Sales	$13,000,000	$13,000,000
Development Costs	$10,000,000	$10,000,000
Senior Debt	$8,000,000	$8,000,000
Mezzanine Debt	$0	$1,000,000
Total Debt	$8,000,000	$9,000,000
Equity Contribution	$2,000,000	$1,000,000
Interest Expense - Senior Debt	$500,000	$500,000
Interest Expense - Mez Debt	$0	$200,000
Total Interest Expense	$500,000	$650,000
Total Costs	$10,500,000	$10,700,00
Development Profit	$2,500,000	$2,350,000
Development Profit % of Costs	24%	22%
Development Profit % of Equity	125%	235%

As illustrated above by using Mezzanine Finance the property developer reduces profit by $200,000 in the above example, or development profit is reduced from 24% to 22%. However the property developer’s development profit as a percentage of the equity contributed almost doubles from 125% to 235%.

It is interesting to note, if on the assumption that the property developer had a total of $2,000,000 to contribute as equity, they could opt for one of the following:

A traditional structure, and make $2,500,000 profit, as that is all the equity available
Undertake two identical projects as outlined above and contribute $1,000,000 each and achieve $4,700,000 profit.

The above clearly outlines the benefit to the developer of freeing up equity.

Mezzanine Finance lenders (investors), also gain considerable benefits from this type of investment as follows:

Fixed term investment
Investment is secured by property
Only projects which are ready to begin immediate construction are eligible
Projects must have pre-sales or pre-leases in place, which are fully verified by GCC
Property developers capacity, capability and track record are fully scrutinised by GCC
Mezzanine Finance final returns are returned in full before the developer has access to any funds from the project

As for the example above the mezzanine lender/investor would place $1,000,000 into the project at commencement of the construction, and in 12 months an amount of $1,200,000 would be repaid.

If you are a property developer looking for Mezzanine Finance for your developments, or if you are an investor interested in Mezzanine Finance please contact Global Capital Corporation for more information.

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