6 Great Reason To Use Mezzanine Finance On Your Next Development
What are mezzanine funding and the reasons to use it in your next development? In this piece, we discuss everything in detail:
Some individuals see mezzanine finance as an alternate option when all other forms have failed, but this is wrong. Many of our clients opt for mezzanine finance even though they can fund their development on their own. The question is ‘WHY.’
Mezzanine finance is used to fill the gap between the developer’s equity and debt provided by the banks. In some cases, a developer will put up equity for around 10% of the cost, the bank will lend between 60% and 80% and the professional lender can make up the difference. This funding is provided as a part of the equity required by the banks on day one, with professional costs plus part of the land acquisition costs and with bank funding the building. On the contrary, mezzanine development finance is rarely used because a developer or homeowner requires additional funds.
How Does Mezzanine Finance Work?
The lenders lend the money at a fixed interest rate for a fixed period agreed by the two parties. Unlike other loans, the interest of a mezzanine fund is calculated from the total loan amount on day one. The reason is that, as the mezzanine loan is used to top up the senior debt facility, the borrower will most likely draw out the full loan and use it at the initial stages of the project.
Concerning interest payment, rolled-up interest is the most used way that mezzanine finance operates. rolled up interest is calculated throughout the development project but only paid from the sale of property proceeds.
In most cases, our clients use mezzanine funding even though they have the necessary cash available. Here are the six reasons ‘why:’
Six Reasons to Use Mezzanine Finance
Elevate the IRR (Internal Rate of Return)
By using a mezzanine fund a developer can significantly boost the internal rate of return (IRR) on their investment. This is best illustrated by the example given below:
| With a mezzanine (£ 000) | Without mezzanine (£ 000) | |
| Gross development value (net) (GDV) | 4,000 | 4,000 |
| Gross development cost (including bank loan) (GDC) | 3,000 | 3,000 |
| Development profit | 5,00 | 5,00 |
| Profit on cost | 25% | 25% |
| Profit on sales | 20% | 20% |
| Bank facility | 2,750 | 2,750 |
| Mezzanine finance | 750 | 0 |
| Total bank and mezzanine funding | 3,500 | 2,750 |
| Equity | 500 | 1,250 |
| Mezzanine interestand exit fee | 227 | 0 |
| Net profit to the developer | 773 | 1,000 |
| Developer’s annualized 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 amount he would have had to put in without it. Not only has the amount of return on investment increased, but a large amount of equity is also freed to use on other projects.
More Control
Developers often bring onboard equity partners to help finance their projects. This can lead to a lot of uncertain issues, not least of which is a lack of control. From our experience, equity partners nearly always want to say how a development proceeds, and this can cause conflicts, stress, and even delay in the development process.
Developers see mezzanine financing as convenient and stress-free equity. In most situations, more than 75% of the return on investment will add to the developer with the balance going towards the cost of the mezzanine finance.
Cost is Charge on Profit
The cost of the mezzanine fund is payable as exit charges on the redemption of the loan. In simple words, most of the finance cost is a charge against profit earned rather than an additional working capital requirement.
Flexibility and Simple Source of Funds
Mezzanine funding is by nature flexible. Every project is different from others and lenders make sure to offer their clients a funding package that works both for the developer and senior lender. Most of the time lenders will accept alternative security in place of the normal 10% cash assurance from the developer. Additionally, they rely on the same valuation and quantity surveyors’ reports prepared for the bank rather than our advisors. This is not always the case with equity investors.
It Can Deal Over the Line
It would be erroneous to propose that a mezzanine fund is never used to get deals over the line. Bank lending to the property sector has reduced considerably 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 deficit, but then continue to use our product on future deals.
Lenders Offer Strategic Assistance
The lender analyzes each project based on its financial, marketing and construction viability to see if it fits within their lending criteria. This analysis includes the project time completion, experience of the developer, and the availability of senior debt funds from a bank.
To discuss mezzanine finance on your next development project, contact Finspace professionals.
