Mezzanine Finance
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Mezzanine Finance
Scott explains how mezzanine finance works and when it’s an appropriate option.
What is mezzanine finance?
So mezzanine finance – or ‘mezz’ finance as we sometimes refer to it – comes in two different types. You’ve got mezzanine debt and debt to equity. Most of the time when we’re talking about mezzanine finance it’s the former, mezzanine debt.
I’ll answer most of the questions today around that because it’s far more common. It’s typically used a bit like a bridging loan, to cover the gap between where a project is and what’s needed to get finished.
So if you’re partly through a development and for whatever reason there’s a shortfall in your running costs, a mezzanine finance lender would come in and cover that gap to get the project finished.
What are the advantages and disadvantages of mezzanine finance?
One advantage is that it sits behind your current primary lender, so you don’t need to refinance entirely. You can leave the existing first charge debt where it is. That’s always useful, because typically that debt would be cheaper.
You can get the additional funding without having to give away any equity or make anyone a joint venture partner.
The disadvantages are that it’s typically at a higher rate, because being a second charge lender is a higher risk position. In the event that it all went wrong and they had to repossess your property, the primary lender gets all of their debts repaid first. The secondary lender gets theirs last – so if the property sells for less than expected because it’s not finished, that second lender is at higher risk of not getting all their money back.
That’s why their rates are higher. There are also slightly higher setup costs, which can start to eat into the profit margins you initially thought you were going to get from the project.
How are debt mezzanine loans structured?
They are very similar to the development loan you already had in place with your primary lender, and they are similar in structure to a bridging loan. The new lender will sit behind your existing lender and interest will roll up or be retained, so here’s nothing to service.
Obviously the quicker you repay that debt, the less interest you’ll have on that, so you could get a rebate at the end.
Are bridging loans and mezzanine loans the same?
Yes, and no. They’re very different products with very different lenders and risk profiles. But from the client’s perspective, they do look similar.
From our side, as brokers, we have a different choice of lenders. There’s a specific risk profile to mitigate, so the requirements from the lender are different. Obviously the project is half built, whereas with a bridging loan you typically tend to have an existing, finished asset. You might be doing a refurb, but it’s on a completed building.
With mezzanine finance, you’re usually partway through a build. So they’re different from our side, but for a client they end up with a very similar result – it’s a second charge like a bridge and it retains the interest like a bridge. But they are two different things.
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What is the difference between senior and mezzanine debt?
Senior debt is just the jargon that we tend to use to describe your first charge lender. That’s the lender that came in first and gave you the primary loan for that development.
They will have done all the affordability calculations and build cost calculations upfront. That senior lender should have lent you enough money to completely build in the first place.
Mezzanine lending usually comes in because there’s been a change of material costs – as we saw during Covid – or there is an incident on site that means additional works are required.
If something falls down or there’s a fault and something needs to be redone, you might need more finance. Or, people can sometimes just get emotionally involved and decide to add a pool or two more bedrooms… the project gets larger and larger and the debt doesn’t cover that. Mezzanine finance can fund those additional things.
Is mezzanine financing risky?
It’s not inherently risky, because there is an affordability based calculation that the lenders do. They will only go to a certain Loan to Value, which will depend on the lender, the loan size and the project. There’s no inherent risk to the client because the interest rolls up.
One potential risk is that if the initial senior debt wasn’t sufficient, and the project keeps expanding above and beyond the finance from the mezzanine lender, the project would run out of money again.
So it’s not the finance itself that’s risky, it’s more about why the client ran out of money in the first place – and mitigating that risk.
How much will a mezzanine finance provider let me borrow?
It does depend on the size of a scheme and what it is. Is the building commercial or residential? What’s the gross development value? What’s your credit profile?
The better your credit, the better the rates you will get. Typically you can get up to 70% or 75% Loan to Gross Development Value (GDV), so it should cover most of the costs. If you’re pushing your Loan to Value beyond that, we need to look at the profit margins and your projects going forward.
Can I use mezzanine finance for residential development?
Yes, you can use it for any sort of development. You wouldn’t find it being used on very small projects, such as people building a house in their garden.
But if you’re building four or five houses or a much larger project it might become more applicable, as you have more chance of going over your budget.
How long does it take to secure mezzanine finance?
It’s pretty quick. These short term products, like bridging, all tend to have similar timescales. It can be arranged as quickly as seven to 14 days.
We want to be aiming for four weeks really, just to make sure everybody’s got time for the valuation to be completed and legals done suitably. We don’t want to rush things too much, but in an emergency it can be done much quicker.
What type of security do I need for mezzanine financing?
I would hope you do have some security at this point. The development money’s probably been spent somewhere. But the project doesn’t need to be at any particular stage for mezzanine finance.
The project is your security, so the stage it’s at will determine how much money you’ll get from the lender. If your project is most of the way finished – its roof is on, it’s almost watertight and it’s just the last fittings and electricals going in, it will be easy to find a lender.
It’s most of the way there and there’s not a lot to finish, so your debt requirement is going to be quite small. If your project is at an early stage and you’ve already blown through all of the development loan, it could be very hard to convince a mezzanine lender to lend you the money to finish.
So while there isn’t a specific security type required, we do need to demonstrate that there is plausibility to finish the project.
Why is it important to work with a broker for mezzanine finance?
A broker is so useful because it’s not straightforward finance. It’s not like going to a high street lender and asking for a mortgage or switching products.
The presentation of your case is very important. So if the project is at a certain stage when you run out of money, how we present that to a lender makes a big difference.
Depending on the broker’s relationship with lenders, we can sometimes negotiate on rates, costs and other things for you. We’ll also help manage the case through. It’s much easier than you going away and speaking to 15 lenders – we could look at a case and know which lenders would say no, which might say yes and which might be in-between.
We know where to look and who to speak to, which saves you a big headache. People in a situation where they need mezzanine finance are probably quite stressed already, and we can relieve some of that pain.
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