An increasing number of applications are being received for mezz finance on construction projects so we thought it would be useful to look at mezzanine funding.
‘Mezz Finance’ is a subordinated credit facility that sits behind the prior position of a senior lender in a development project. It can take the form of a second mortgage debt or a blend that is a second mortgage that can be converted to preference equity (‘pref equity’). While the debt portion of a mezz facility is subordinate to senior debt, it is senior to other creditors. But once converted to pref equity becomes subordinate to debt plus creditors, but senior all other equity. So this waterfall of seniority, that determines the position in the line of creditors in the event of default, also determines the rates that will be charged to reflect the risk position. Clearly, mezz debt would only be converted to pref equity if the realizable return proves higher as equity than the interest rate earned on the debt contract. This is rarely the case.
Here is how this situation looks in graphic form:
The above example is a pretty fair representation of what comes to us. What’s immediately obvious is:
- The debt and mezz facility assumes the entire development cost risk
- The mezz facility would be priced at a rate higher than the anticipated gross realizable return to the developer and it would never convert to pref equity because the return and creditor seniority would be lower
In most cases we see the project equity offered by the developer tied up in the land value and this is fine so long as it is sufficiently debt free. However, more often than not, these days we find it is debt ridden and the developer is hoping that the value the land represented in the feasibility on an ‘as-if-complete’ basis will be enough to prove committed equity. It is not, because this value is only realizable at the end of the project and therefore it does not exist as equity coverage during the life-cycle of the project, particularly where there are no, or insufficient, presales to cover peak debt.
The mezz debt costs are borne from the start as the senior lender will demand that the developer demonstrate he has the capacity to meet the total development costs before providing access to funding. The high interest costs on the mezz slice are therefore costed into the project to determine the negative affect on gross realisable value. This causes a problem for the senior debt provider when it causes the gross realisable value to drop below their acceptable values.
Lastly, don’t expect a mezz lender to sit behind a second tier or other private lender whose rates in default will rapidly erode equity.
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