Qandor Issue: Mezzanine Finance
A valuable tool or a reckless risk?
Truly understanding different types of debt and how to use them safely is fundamental to being a prudent and successful property developer. Daryl Thorpe of RDT Invest discusses the pros and cons of stretching your debt with second-charge mezzanine finance.
What is mezzanine finance for property development?
Put simply it is additional debt, a ‘top up’, that a developer may take out over and above their Senior Debt or Development Finance. It is sometimes also referred to as Junior Debt, and provides an additional ‘layer’ of funding. Increasing the leverage will reduce the proportion of equity required as part of the overall capital requirement.
This additional debt ranks second to the development finance, secured by way of a second charge, with the senior debt provider holding the first charge. As the risk for the mezzanine lender is greater, the interest rate will be higher than that of senior debt.
What are the advantages to using a mezzanine loan?
There are several which include:
- Reducing the amount of equity required by the developer
- Enabling the developer to improve their cash flow and consider additional development projects by retaining liquidity of their own
- Increasing the return on the developers own equity investment
- Allowing the developer to retain more, or all, of the project profits, compared to an equity partner who will take a share of profits
Despite the advantages then, why does mezzanine finance often have negative connotations?
When everything goes according to plan then the advantages outlined above will be realised. However, a property development project is rarely a smooth journey, so it is important to understand the risks in using this type of debt:
- “Interest never sleeps” – whilst this is true of all interest-bearing debt, this is heightened with mezzanine lending as it is often the most expensive. So, any timeline delays can quickly erode profits
- Deed of Priorities – typically the Senior Lender will get their money back first out of sales proceeds, meaning the more expensive debt is retained for a longer period (albeit a relatively small proportion of the overall capital stack)
- Personal Guarantees – developers are often required to provide these for the full mezzanine loan amount, and since the equity buffer is reduced, the liability will be potentially triggered sooner. In short, less room for error
- Default Terms – if timelines are delayed and go over term, situations arise when the interest rate could rise further, thereby accelerating the issues above. Whilst this will depend on the detail of the terms, and the flexibility of the lender, it is another cautionary note
Is mezzanine finance a valuable tool or a reckless risk?
Like many aspects of property development, there is no one size fits all when it comes to structuring funding for a project. Be aware of the pros and cons of all the options available.
Some key considerations when looking not only at mezzanine funding, but all the financing options, including senior debt and equity, include:
- Timeline creep – think how to best mitigate timeline overruns. Be realistic at the outset in appraisals; be prepared to hit the ground running as soon as the funding is in place; plan sales and marketing at the beginning of the project not at the end of construction
- Sensitivity analysis – create ‘what if’ scenarios to understand what the worst and best-case positions are
- Terms & Conditions – be aware of all the key clauses, particularly around when projects start to go wrong and/or run over term
- Choose your lenders wisely and seek recommendations. It is not always just about cost, but also other characteristics such as flexibility and integrity
So, if you are confident and realistic in your project and have analysed all the pros and cons, then think of mezzanine funding as a useful and valuable tool to have available at your disposal for suitable projects.
Daryl Thorpe is co-founder and Managing Director of RDT Invest, and a Founding Member of Qandor. firstname.lastname@example.org
RDT Invest is a privately-owned Principal Lender and Debt Advisory service for small and mid-sized developers in the UK providing equity, mezzanine, bridging and development finance from their own capital, or that of their strategic funding partners and investors.