Mezzanine Finance and Preferred Equity
For Property Developers
Mezzanine Finance and Preferred Equity is a way to increase the property developers borrowing potential beyond the limitations of traditional construction finance facilities.
Mezzanine finance is a form of subordinated debt behind senior debt in terms of ranking on any claim on property assets; and ahead of equity, generally secured by a second mortgage.
In summary, mezzanine debt fills the funding gap between the property developer’s equity and the amount of the senior facility available.
Preferred Equity works in a similar way to mezzanine finance, but no second mortgage is placed on the property to be developed.
Diagrammatically, development project risk can be illustrated as follows:
General Project Time Line:
1. Land is identified
2. Development Plan and Marketing Plan are conceptualised
3. Land is secured (either purchased or optioned)
4. Development proposal is prepared (architectural plans etc)
5. Proposal is submitted to relevant authority for approval
6. Marketing Plan is initiated (i.e. presales begin)
7. Development is approved
8. The Construction Facility is put in place
9. Construction commences
10. Construction completed
11. Project is sold
Experienced and financially savvy developers are interested in mezzanine finance / preferred equity as it provides the following benefits:
- It gives the developer the power to determine the level of equity (if any) they wish to contribute to a project
- It is generally cheaper than equity; and provides a higher rate of return on equity
- The borrower can use their equity elsewhere, effectively diversifying risk
- The property developer can continue with the project on a ‘stand alone’ basis
- Control is retained by the developer, not Joint Venture partners
- Mezzanine finance is passive provided the project is performing to expectations
- It can be raised relatively quickly as opposed to equity
Lets have a look at an example and the potential benefits.
End Value (GRV):
Total Costs (excl interest):
Senior Facility Interest Rate:
Mezzanine Debt Facility Interest Rate:
Note: that rates and figures are for illustrative purposes only.
Project Structure Comparison
|| Traditional Senior Debt
Senior and Mezzanine
| Construction Costs
| Senior Facility
| Mezzanine Debt Facility
| Equity Contribution
| Interest Expense – Senior
| Interest Expense – Mez
| Total Interest Expense
| Total Costs
| Profit % of Costs
| Profit % of Equity
As illustrated above, by using mezzanine loans the developer’s profit reduces by $200,000 in this example, from 24% to 22%.
However the property developer’s development profit as a percentage of equity almost doubles, from 125% to 230%. Based on the above if a property developer had $2,000,000 equity, they could opt for either:
- A traditional structure, and make $2,500,000 profit, as that is all the equity available
- Undertake two projects as above and contribute $1M each and achieve $4.7M profit
Clearly there are benefits to the developer of freeing up equity
Mezzanine finance lenders (investors) also gain considerable benefits from this type of investment:
- 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