Mezzanine finance sits on top of senior debt and is a part-equity, part-debt solution.
It takes second priority in repayments after the senior debt and takes a second charge over the property.
Mezzanine funding is mainly used by borrowers with little liquid assets, as it reduces the amount of equity investment the project requires.
Due to its higher risk, mezzanine finance will tend to be more expensive, but lenders will usually take a careful and personal approach to understand the developer’s project to allow for a more flexible solution.
Why has it grown in popularity?
The banking crisis played a key role in mezzanine’s resurgence
“The resurgence of the use of mezzanine finance for property development came about due to the credit crunch and the fact that many of the previously well-known property lenders either ran to the hills or considerably scaled back on their leverage appetite,” said Mark Quigley, managing director of Contour Capital.
Michael Dean, principal at Avamore Capital, felt that since the crisis, development lenders had not been able to offer particularly high leverage, which in turn has required more equity from developers and dragged returns on equity down.
“Developers have turned to mezzanine lenders to plug the leverage gap that has been left since the crisis (albeit not fully as the combined LTCs [loan-to-costs] available from senior and mezzanine lenders is still less than what was available from banks pre-recession).
“Despite stretch senior options being available now, many developers prefer to go with clearing banks to do the senior piece and mezzanine lenders to top up the leverage as the blended annual rate can be cheaper than a ‘one-stop’ solution provided by a stretch senior lender.”
Martin Gilsenan, director of sales at Iron Bridge Finance, felt there had been a growing understanding from developers that mezzanine finance was an alternative form of equity.
“At the same time, more banks and senior lenders are comfortable with clients obtaining mezzanine funding – as long as it doesn't reflect a shortage of equity or ‘skin in the game’, but allows developers to increase their profitability.”
Matthew Wyles, executive director of Castle Trust Capital, felt the re-emergence of pure mezzanine was a natural evolutionary stage in the economic cycle.
- Plugging the gap for developers
- Contour completes mezzanine loan for £14m development
- A guide to mezzanine finance
“Arguably the bifurcation of mezzanine from senior is [a] more efficient market mechanism than senior stretch.
“By blending equity, mezzanine and senior in each case, clients get the benefit of more choice and the cost of the aggregate structure is likely to be lower than stretch senior and more flexible to boot.”
Will more lenders look to offer mezzanine finance?
Mezzanine lenders will work closely with borrowers during a project
“Unlike the proliferation of lenders in the senior debt, stretched senior debt and bridging lending spaces, mezzanine finance is still seen as somewhat specialised and the second charge market doesn’t have nearly so many participants,” said Mark.
“That said, the prevalence of mezzanine development finance is likely to increase as senior lenders move further up the risk curve in order to meet their return requirements.”
Michael revealed that Avamore had previously looked into offering mezzanine finance.
“I don’t see more entrants into the mezzanine space at this point in the cycle,” he said.
“It’s certainly not something we would consider.
“We looked at mezzanine a couple of years ago, but concluded that it didn’t make sense for us.
“I think that view is probably shared by the majority of investment professionals in real estate right now."
Matthew felt that the mezzanine finance approach would only be cost effective to arrange for larger transactions and so it was likely that the smaller deals would continue to be served by one-stop shop lenders in the traditional way.
“It should be understood that mezzanine is attractive to those investors with relatively high-risk/high-return mandates.
“These investors are, understandably, more sentiment driven and more sensitive to macroeconomic trends.
“If for some reason, markets move from the current ‘risk on’ setting to ‘risk-off’, the supply of mezzanine funding could reduce rapidly.
“By definition, it is a more volatile market.
“Senior and, to some degree, senior stretch funding supply will be more stable through the cycle.”
Martin added: “Mezzanine isn't a market for speculative projects – it's a specialist, niche area, so a lender's knowledge of development, experience and track record are absolutely vital.”