You may have heard the terms Senior Debt and/or Mezzanine Debt (Mezz for short) used in a property development / construction finance context. Here’s a brief and simple explanation of these terms and an example as to when these finance instruments may be used.
For the purposes of this article, we will use a construction scenario with the following details:
Total Development Cost (TDC): $20M
Loan to Cost Ratio (LCR): 75%
Drawing on the above example, if a lender is only willing to lend up to a maximum LCR of 75%, the maximum loan the borrower in the above example would be able to secure would be $15M ($20M x 75%). This debt is referred to as the “Senior” portion which is usually secured via a First Mortgage over the property that is being developed.
If the borrower is able to secure a Senior loan of $15M, that means that they require a further $5M to cover the full TDC. The borrower may be able to cover this from their own resources (i.e. cash or equity) but if not, they may then require Mezzanine finance.
Now, let’s say the borrower has $3M in cash to contribute the the project but needs to borrow a further $2M as they do not have the ability to cover the remainder of costs from their own resources. They may approach a lender to lend them this amount which would be referred to as the “Mezzanine” portion which is usually secured via a Second Mortgage over the property that is being developed.
The Mezzanine portion is subordinate to the Senior portion which makes Mezz debt inherently riskier and therefore more expensive as a consequence.
Enables the borrower to extract the maximum equity from the project, allowing them to utilise their cash reserves elsewhere;
When cash is tied up in other projects, it can be utilised as a form of cash-out to enable the securing of another potential development site (if a good opportunity suddenly presents itself); and
May assist in avoiding the use of additional security properties to secure a project, thereby potentially mitigating the developer’s risk to the subject property / project.
Can be quite expensive with interest rates starting in the double digits;
Increases the likelihood of negative equity in a declining property market; and
Some major lenders may prefer not to finance projects that require Mezz.
If you need any advice relating to a property development, feel free to reach out. We will be happy to assist you in getting your project ‘finance-ready’ and if necessary, introduce you to our network of property professionals (including builders, lawyers, agents, project managers, engineers etc).
Alternatively, if you are interested in lending your own funds to potential borrowers as either a Senior and/or a Mezz lender, please feel free to get in touch.
Disclaimer: The information provided herein is for general information purposes only and does not constitute specific advice. It should not be relied upon for the purposes of entering into any legal or financial commitments. Specific advice should be obtained from a suitably qualified professional before adopting any investment/financial strategy.