Home » What is mezzanine finance, and how do you use it?
Mezzanine finance is an effective way to raise capital for development projects and can be used to lower the deposit required by a developer or investor.
As Stephen Clark, from property development finance broker Finbri, explains, “With high street banks becoming increasingly cautious of lending to the property development market, mezzanine finance can provide welcome relief. By providing the extra funding that a senior lender cannot, mezzanine finance can allow developers to continue with profitable projects that may have otherwise run out of funds.”
What exactly is mezzanine finance?
Mezzanine finance is a second charge development loan that provides additional funding above and beyond what the senior debt (first charge) provides. When the developer or development company does not have enough funds to complete the project with the senior debt alone, it is used to supplement the senior debt.
For example, a principal lender or the senior debt lender may be able to lend 65% of the cost of a project; however, the developer may only wish to put 15% of their equity into the project. A mezzanine lender could then provide the remaining 20% and make up 100% of the finance needed for the entire project.
How does mezzanine financing work?
Mezzanine finance works by lending a developer the funds for a project at a fixed interest rate for a specified period. The funds can be released as the project progresses, tranches, or at the start if the borrower requires it as a deposit or for site acquisition.
Lenders protect their mezzanine finance funds by taking a second charge on the development as security, whereas senior debt providers take the first charge on the property.
Most often, mezzanine finance is used when a developer is short on finances, as it can provide them with the extra funding needed to complete the project successfully.
Mezzanine finance can also be used when the developer wishes to commit to more projects concurrently and doesn’t want to risk using all of their available capital on just a single project.
How does mezzanine finance compare to other forms of development financing?
Mezzanine finance isn’t as common as senior debt, as it’s only provided by specialist mezzanine lenders, whereas banks can lend senior or principal finance. However, many bank lending facilities have been more cautious in recent years about lending to the property development market, which can impact the amount of funding available for a developer.
Mezzanine finance can help fix this shortfall and give developers the funding they need to embark on projects that may have otherwise been unobtainable.
Compared to a senior debt lender, which almost always has the first charge on a property, a mezzanine lender takes the second charge. If there is a drop in the project’s GDV (gross development value), there may not be enough funding left to cover both first and second-charge debt. In specific scenarios, the borrower may only have enough to cover the senior debt, but not the mezzanine debt, making the lending much riskier for the mezzanine lender.
Due to the increased risk, the interest for mezzanine finance is higher than that of senior debt, depending on lenders’ risk assessment. Additionally, due to the threat, mezzanine finance lenders often only provide funding to experienced developers with substantial portfolios.
Why would you use mezzanine finance?
Developers use mezzanine financing for various reasons, most common uses are where:
the principal lender requires a more significant cash contribution than you have
you want to retain capital for other potential projects
the project was undervalued during the application, requiring an increased assistance to achieving the deal
Mezzanine finance can also be used for property development businesses by helping with:
Fund expansion of the business
Project development costs
What are the advantages of mezzanine funding?
Mezzanine financing has numerous advantages, including:
Boosting long-term capital
Once completed, development projects typically profit the developer or development company significantly. However, the project and its potential profits may be jeopardised if there is a shortfall. Mezzanine financing can assist in raising the additional funds required to ensure that the developer or development company can complete the project while increasing its long-term capital.
Deductible on taxes
The interest paid on mezzanine funding is tax-deductible, which can help a developer’s capital even more.
Mezzanine financing can be provided at any stage of development as long as the senior debt is in place, giving this type of finance flexibility.
Preventing missed opportunities
If a developer falls short on funding, it can jeopardise the project’s timeline and prevent them from selling at the most profitable time. Mezzanine financing can provide the funds required to avoid this from happening.