Mezzanine finance – A brave new world
The property world has yet to recover from the banking collapse of 2008 and times are still proving to be hard for property developers. Many developers are finding that their once reliable senior funders are not able to provide even close to the financing given pre-crash. This is presenting them with a stark reality – find the balance from alternative sources or abandon the project.
The difficulties encountered with finding conventional funding have provided wide opportunities for mezzanine finance providers. These are now being used by borrowers to help bridge the gap created by the capital constrained senior lenders.
Senior lenders (otherwise known as first secured lenders) are the primary lenders to a project. They are referred to in this way because their loan is considered senior to all other claims that could be made against the borrower and would be secured by way of first ranking security over a borrower’s assets. In property projects, mezzanine lenders provide a second layer of debt funding behind the senior lender.
Following the onset of the financial crisis the use of a combination of senior debt, mezzanine loans and equity has become increasingly the normal funding structure for developments – in place of the more traditional financing structure of senior debt and equity. Below is an example of how the financing for the acquisition of a £10 million development has changed since 2008.
The mezzanine lender (or lenders – there is often more than one) typically takes a second charge over the development which ranks behind that of the senior lender. In practice, this means that in the event of default by the borrower a mezzanine financier will only get paid after the senior lenders’ debt has been paid off. This increased risk is reflected in the cost of the mezzanine finance with the corollary that the cost of debt funding schemes is now considerably more expensive.
“The difficulties encountered with finding conventional funding have provided wide opportunities for mezzanine finance providers. These are now being used by borrowers to help bridge the gap created by the capital constrained senior lenders.”
The terms of senior debt vs. mezzanine funding
Nonetheless, competition in the market over the last 2 years has in general driven down the average return sought by providers – from 20% in 2011 to around 15-17% in 2012/2013. Returns to mezzanine lenders are achieved through various structures depending on the particular development and lenders. Typically this might be based on a split between current paid interest of around 10-15% (to be paid monthly throughout the term of the loan) and accrued interest of up to 15-20% paid either at the end of the term of the loan or after 5 years, depending on the length of the term.
The lenders will often also charge an arrangement fee of between 1 and 5%.
Other arrangements offered by mezzanine financiers may involve them offering a more competitive interest rate (closer to those offered by senior lenders) in exchange for a share of profits of the completed development. For example as much as a 30-35% share in the profits would be sought by mezzanine lenders.
Mezzanine lenders are made up of a mixture of asset fund managers, corporate and investment banks, hedge funds, property companies, sovereign wealth funds and high net worth individuals. Lenders have different approaches and restrictions on the lending they can undertake, determined to a large extent by the requirements of their investors. For example, property companies tend to be able to lend on higher risk projects. Compare this to projects favoured by sovereign wealth investors who are generally only associated with prime central London schemes promoted by well known developers.
The appetite of the senior lending market for development projects remains limited and senior lenders often seek to impose onerous terms on the borrower – for instance, significant pre-lets to tenants with strong financial credibility. This can mean that the parties are slow to agree terms for the loan and for credit approval to be obtained by the senior lender. As mezzanine lenders can only lend to a project where senior lending is already in place, the slow pace in such transactions being agreed has a knock on effect on the mezzanine market.
As a result of these frustrations, the number of active mezzanine lenders has contracted over the last 12 months. Many are starting to explore their ability to offer a wider selection of products which also seek to accommodate the risk appetite of their different investors. Other products being explored by the lenders in this market include senior debt and whole loan facilities on a short term basis.
Overall, whilst the banks remain slow to open up their books to real estate developers it provides the more flexible and innovative debt funds with the opportunity to make their impact on the lending market. Those with the appetite and strategies to cover a wide range of risk profiles are set to make a gain during these cash constrained times.