We are often asked about mezzanine finance when dealing with developers. Today we wanted to put a blog together that defines what mezzanine finance is and how mezzanine financing works .
What is mezzanine finance?
Mezzanine finance is an additional layer of debt in your capital structure above your senior (bank) debt to help you finance a project or acquisition. It is utilised in property development, commercial property and business debt but here we will focus on property development.
Mezzanine finance will rank behind your senior lender which basically means that the mezzanine financier would hold a second mortgage whilst your bank (or similar) will have the first mortgage. In practice this means that the mezzanine financier is repaid AFTER the bank, but before equity.
Mezzanine finance therefore sits between the senior financier and the equity and hence is the ‘mezzanine floor’.
How much does it cost?
Because mezzanine finance ranks after the senior funder it holds additional risk and therefore will cost more than your senior debt. The cost may vary but we typically see a total cost of this debt ranging from 20% - 30%.
This is normally broken up between an interest rate and an establishment fee. (say 20% interest rate + a 5% fee). Unlike senior debt in property development there isn’t often a line fee attached as the full amount of Mezzanine debt is typically drawn on day 1 and therefore it would be irrelevant.
Why would I use mezzanine debt?
Mezzanine debt is used to increase the leverage you have on a project. It can be a more efficient source of capital for you to complete a project. As mentioned above, it is expensive, so its best use is in a situation where your capital is either required elsewhere or you don’t have enough capital for the project.
If you are able to invest your funds in another project that will generate a return above the cost of the mezzanine debt then that is a good opportunity to consider mezzanine finance to allow you to invest in that second project to move that on whilst you complete the current project.
How can I get mezzanine debt?
Because of the lack of control for mezzanine debt, typically the lender will look to invest in projects that have allayed significant risk within the project. This may encompass things such as securing a good head contractor on a robust commercial construction contract including LD’s, Retentions and Bonds, being an experienced developer, having a good senior lender and the project being simple in nature.
The most common thing a mezzanine funder will look for, however, is the security around the loan repayment on completion. In effect, pre-sales. As the lender has little to no rights (see DOPAS section below) they will want a high level of certainty around repayment of the senior lender's debt on completion of the development. With the senior lender repaid, the mezzanine financier would move into a first mortgage position providing them an adequate level of control to manage their exit. Most often, therefore, mezzanine financiers will look for projects with sales adequate enough to cover the senior debt position at a minimum.
Another important consideration for mezzanine financiers is the size of the transaction. There are some providers that will provide small second mortgage positions, however, for the most part mezzanine providers will want to invest at a meaningful level and therefore seek positions of $1M+.
What is a Deed of Priority and Subordination?
A Deed of Priority and Subordination, DOPAS for short, is a formal legal agreement between the senior (bank) and junior (mezzanine) lenders. The agreement covers what rights each party has relative to their lending and the client. Most often what it will ensure is that the senior lender remains in control of the project and can do things like lend further funds to complete the deal if they see fit.
What this will mean for the mezzanine financier is that they will have little rights to force a default position for the borrower and could in practice have the senior position extend to the point that they are out of the money (i.e. the first mortgage loan gets so big that once the property(ies) are sold at the end there isn’t enough money left over to repay the full mezzanine loan).
Most often the primary right for the mezzanine financier is for them to be able to acquire (buy) the debt from the senior financier to place them into control (first mortgage).
Who will a mezzanine financier lend behind
Theoretically you can secure mezzanine debt behind any financier, however, most established financiers will be picky as to who they provide finance behind. Again, this is another mechanism of them managing their risk.
In practice this means most mezzanine finance sits behind a main trading bank (I.e. BNZ, Westpac, ANZ, KiwiBank & ASB). Some others will look further abroad, however. Capital Group, for example, will lend behind FMT as they own the book and therefore have a close enough relationship to do so.
Who are the mezzanine financiers in New Zealand
There are a number of entities that will partake in mezzanine finance such as family offices, solicitor funds, high net worths and other non-bank entities. The most prominent mezzanine providers in New Zealand, however, are Capital Group and Pearl Fisher. NZMS, Killarney Capital and Tessera also provide mezzanine finance.
As always reach out if you have a project and need some help.
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