In 2008, the global financial crisis severely impacted real estate and the lending market, in particular. We now face a different emergency — Covid-19 — which is perhaps one of the biggest crises of our generation and will potentially change the face of healthcare, politics and real estate as we know it.
As we find ourselves in unchartered waters, will the market for mezzanine finance stand strong?
A brief history of mezzanine finance
Since the GFC, mezzanine finance has gained prominence as an alternative debt solution and is characterised by higher leverage potential. Following the collapse of Lehman Brothers in the US and the leveraged finance markets being impacted, lending evolved in response to senior bank debt not providing the same levels of gearing that it did pre-crisis. In the wake of 2008, and with confidence emerging, investors sought new strategies and pursued greater returns in a low yielding market. This began with the emergence of stretched senior products and the growth of preferred equity providers, bridging the gap between bank debt and sponsors’ equity. Aggressive mezzanine finance providers followed suit, offering a highly leveraged tranche of junior debt, with cost-effective blended returns.
We know that, over the last 10 years, this has led to mezzanine players having a greater market share, with more room in which to compete. Overall, mezzanine issuance grew during this period — in terms of capital deployed and the number of new entrants to the sector — as market confidence was restored, and investors chose to leverage up. Mezzanine finance quickly became a useful instrument for real estate players whose corporate strategy matured. Investors and developers became less defensive and were encouraged to grow and leverage up to enhance their return on equity.
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The mechanics of mezzanine finance
Mezzanine finance is a tranche of debt within the capital stack that sits on top of the senior facility, and below the equity. It is ‘the jam in a sandwich’, and a slightly more complex form of real estate finance. Mezzanine provides a sponsor with the opportunity to increase gearing and borrow more capital, reducing the overall requirement for equity.
The interest rate on mezzanine facilities is typically priced slightly higher than that on senior debt to reflect the level of risk that the lender undertakes. Mezzanine finance is drawn before the senior facility and is repaid later, meaning that the capital is often deployed for a longer period — hence the higher risk profile. The lender will sometimes take an additional form of security (beyond a second charge), such as a debenture, or cross-collateralise the scheme with other projects.
The market for mezzanine finance is well established. Many investors and developers are familiar with the product and what it is used for. However, in the face of unknown certainties, mezzanine finance can result in expensive debt and consume profits. Borrowers are often familiar with its use, but sometimes they do not fully understand the adverse consequences of cost overruns, with contractors going bust and downward markets often too easily forgotten.
Being heavily dependent on mezzanine finance can be devastating for, not only the development, but also the overall health of a business. If used effectively, however, it can allow sponsors to scale-up and acquire larger sites with a limited amount of equity. Sponsors can also achieve higher levels of leverage and more lucrative returns on the equity committed. Mezzanine finance could, therefore, be a useful recourse for more investors and developers in the coming months.