In property development, mezzanine financing is a hybrid loan that can be a flexible and useful tool in a developer’s armoury for project completion.
But what are the benefits and drawbacks of mezzanine finance? How does it differ from a bridging loan, equity finance, or various types of exit funding? When should a developer consider a mezzanine loan over another option?
Well, this post explains just that, helping you understand how and when it’s used, and whether it will suit your situation.
What is a Mezzanine Loan?
Mezzanine financing in property development is a hybrid form of capital that sits between senior debt, such as the primary mortgage or construction loan, and equity in the funding makeup. It fills the gap when a developer needs more capital than a senior lender will provide, but wants to avoid diluting ownership by bringing in more equity partners.
As a form of second-charge debt, it sits below the senior debt but above any equity obligations. Generally, lenders will provide up to 20% of the GDV, but with higher interest rates, typically in the 12%-18% region. As a hybrid loan, the lender will also take a share of the profits, although less than typical equity financing.
Should the borrower default, the primary lender will be paid first, and the mezzanine lender second, but before any equity investors.
What are the pros and cons of mezzanine finance?
While mezzanine finance can be a useful tool for property developers, it’s not right in every situation. It’s vital to understand the benefits and drawbacks before making a decision.
The Benefits of Mezzanine Finance
There are several benefits of mezzanine finance, such as:
- Increased overall funding: mezzanine financing increases the total amount a developer can borrow, above what a traditional lender may agree to, allowing for larger, more ambitious projects.
- Plugging funding gaps: mezzanine finance fills potential gaps in funding not covered by equity or traditional financing, helping ensure projects stay on track.
- Preserves developer equity: instead of bringing in new equity partners, the developer gets to retain a greater share of the profits.
- Maintains control: equity partners often want an element of control over decision making. Therefore, preserving equity helps maintain control for the developer.
- Flexibility: agreements can be tailored to the project’s needs, with options such as rolled-up interest (i.e. paid at the end rather than monthly), or part-rolled interest, giving developers breathing room during the build phase when cash flow can be limited.
- Quick access to finance: mezzanine financing is often much faster than arranging traditional loans or equity agreements.
The Drawbacks of Mezzanine Finance
Of course, mezzanine finance is not for everyone and there are some drawbacks, such as:
- Higher cost of borrowing: increased risk for lenders often means higher interest rates, and ultimately, less profit from the final project.
- Increased risk: the developer also takes on more risk by layering additional debt on top of the primary debt. If things go wrong, or the project doesn’t sell for the projected price, the developer could end up in negative equity.
- Increased complexity: adding another loan agreement onto primary funding can add legal and financial complexity to the project.
- Loss of control: while mezzanine finance maintains developer control compared to alternatives such as equity finance, it still involves introducing another party, who can and may take control of the development if there are delays or other problems.
When should a property developer consider mezzanine finance?
A property developer should consider mezzanine finance when the funding provided by other arrangements doesn’t fully cover what is needed, and the developer either lacks sufficient equity to cover the gap or wants to preserve capital.
It is particularly well-suited for when a developer wishes to retain full ownership and control of a project, rather than bring in a joint venture or equity partner. Some developers may also choose a mezzanine agreement for its speed. However, a bridging loan or other form of finance can also be viable options here.
Mezzanine finance is best when the numbers genuinely support it. Profit margins need to be strong enough to absorb the higher cost of borrowing, and the developer must have a clear and credible exit strategy. It often works best for projects in proven markets where demand is reliable.
When should a property developer look for alternatives to mezzanine finance?
If margins are tight or the market is not considered reliable, it may be best to consider alternatives to mezzanine finance, as taking on further second-charge debt can increase the financial risk.
Instead, a developer can explore options such as a bridging loan, equity or exit finance. Each can offer a more straightforward and cost-effective solution depending on the specific circumstances.
For example, a bridging loan is faster to arrange and better suited to short-term funding needs, without the complex arrangements that mezzanine finance can require. Equity finance, while it means sharing profits, removes the pressure of debt repayment entirely and aligns the funder’s interests with the developer’s success.
Lastly, exit finance is ideal in the later stages of a development when it’s near completion, allowing the developer to refinance the project in a cost-effective way.
Securing Property Development Finance
If you’re looking for property development finance in the South East, don’t hesitate to contact Hunter Finance today. We’re always keen to work with ambitious developers, and can often provide an agreement in principle within 7 days.
