Property Developers – what to do when you don’t have enough cash…..
In working with developers, I’ve found that often the next project comes along before the current project has been sold.
Let’s say the current project is a development of 10 flats. The developer may have finished the development and be in the process of selling the flats when they see a new deal which is their ideal next project.
The problem is the bulk of their cash is still tied up in the current project and won’t be available until they’ve sold all 10 flats.
As a result, they have limited cash resources to inject into a new deal.
This is an all too common occurrence, which means developers often miss out on great opportunities, which can of course be very frustrating.
The solution might be mezzanine finance.
What is Mezzanine Finance?
When it comes to residential development, there is essentially three types of funding: debt finance, mezzanine finance and equity finance.
Debt finance is the main loan taken out to assist with the development project. It will typically be secured by a first legal charge over the freehold of the property being developed and the lender will charge interest on the loan, with that interest being rolled up until the end of the development in the normal way.
Lenders offering debt finance on residential development will typically lend the lower of 70% – 75% of the total project cost or 55% – 60% of the GDV (Gross Development Value).
By way of example, let’s say the total cost of a project including land purchase, development costs, professional fees and interest comes to £3,000,000 and that the GDV is £4,000,000.
The maximum amount of senior debt is therefore likely to be in the region of £2,200,000
Equity finance on the other hand is the developers cash injection into the project. So, in the example mentioned above, if the senior debt is £2,200,000 and the total project cost is £3,000,000, that means the developers equity into the deal needs to be £800,000.
Which brings me to mezzanine finance. Mezzanine finance is the “bit in the middle” that sits between the debt finance and the equity finance.
Mezzanine Finance explained:
There are several lenders who specialise in mezzanine finance. These lenders will typically lend up to 90% of the total cost of the project, providing this doesn’t exceed 75% of the GDV.
In other words, they lend the additional “top slice” finance that sits on top of the main debt finance.
Again, using the example mentioned above, 90% of the total cost of the project equates to £2,700,000, which is well inside the maximum limit of 75% of the GDV
So, in this example the debt finance is £2,200,000. And the mezzanine finance is therefore the difference between £2,700,000 and £2,200, 000, in other words £500,000.
As mentioned a moment ago, with only debt finance in place, the developer needs to inject £800,000. Now with mezzanine finance also in place, the amount of cash the developer needs to inject has reduced to £300,000.
That’s mezzanine finance – the funding that sits as additional funding “on top” of the debt finance, with the result that the developer does not need to inject as much equity finance.
What are the costs?
Mezzanine finance is of course more expensive than debt finance. A typical debt finance deal for a residential development will have an interest rate of 7.5%. Mezzanine finance will more typically be in the region of 16%.
Whilst as a headline figure, 16% may sound expensive, when looked at in the context of the total borrowing, the “blended rate” for the debt and mezzanine finance combined usually comes in at around 9% – 9.5%.
A mezzanine lender will charge both an arrangement fee and an exit fee and these are both in the region of 1% – 1.5% of the amount borrowed.
The mezzanine lender will take a second charge on the property behind the main lender, and will work closely with the main lender.
That means both lenders will normally use the same valuers, monitoring surveyors and solicitors which is of course both a cost and a time saving.
Pros and cons of mezzanine funding:
- Can make the difference between a developer being able to proceed with a project or not
- Offers increased gearing against the project
- Means the developer can inject less cash
- If the development doesn’t go as planned, the margins are much tighter for the developer on exiting the project
- It is more expensive than debt finance
- Mezzanine lenders are often more selective about the types of deals they will consider
Mezzanine finance is a great option for a developer who for whatever reason wants to put less cash into a project. It often enables a developer to proceed with a project that otherwise wouldn’t have been possible.
However, like all finance it needs to be carefully considered and I would suggest making sure you use a reputable lender who ideally comes recommended.
If you’d like to find out more, why not give us a call on 020 8949 2122.