With so much jargon in the financial sector, it’s easy to think of a term such as mezzanine financing as confusing or opaque. However, the opposite is actually true here. So, what’s mezzanine financing in commercial property finance? It’s all in the name, really.
Much like the mezzanine floor of a building sits between the ground floor and the first floor, the same analogy can be applied to its role in property finance, as it sits between senior debt and an investor’s own equity contribution.
How does mezzanine financing work?
It bridges the gap between the senior debt financing available to fund a project and the equity an investor has available to put into the deal. For example, an investor might only be able to obtain 70% of the property development funding required in the form of traditional senior debt and will need equity to cover the rest. If there isn’t enough equity available, they’ll either require additional equity investors or another financing source, such as mezzanine financing, to conclude the deal.
Mezzanine financing is popular in commercial property deals since the property itself can be used as security for the mezzanine debt, particularly when the senior and mezzanine debt providers are the same party. This enables property developers to facilitate deals faster. At the same time, it gives the lender’s peace of mind since there is tangible security.
The benefits of mezzanine financing to the borrower:
- It reduces the amount of equity needed to finance the deal.
- It increases the return on equity investment.
The benefits of mezzanine financing to the lender:
- There’s the potential to earn a higher return on the loan.
- The Lender still retains the benefits of ranking prior to the investor’s equity and being secured by the mortgage bond over the property (albeit generally ranking behind the senior debt).
What are some of the risks of mezzanine financing?
As with any financial deal, there are potential risks or drawbacks of mezzanine financing, so it’s important that you consider the following:
- As mezzanine debt is considered to be higher risk than traditional senior debt, it will attract higher interest rates, fees and/ or profit shares.
- If a deal doesn’t work out as envisioned, there are generally similar implications to those following a default under traditional debt, for example relating to penalty interest or foreclosure on the property.
- A potential loss of control. Pay close attention to the terms and conditions, as there may be criteria and timelines that a borrower must adhere to.
What do mezzanine lenders consider when looking at a transaction?
Examples of things that mezzanine lenders in the commercial property market typically consider:
- The client’s track record in the specific property type and in property development if a new build.
- The fundamentals of the property in question.
- Ability of the property to generate sufficient cashflow to pay interest and capital or other sources of repayment.
- The ability of the client to make good on cashflow shortfalls or cost overruns if a development project.
Should you consider mezzanine financing?
The answer to this question depends on your specific requirements. It’s essential to structure the appropriate solution to cater to your property transaction and needs.
To do this, you’ll require a team of experienced banking and property professionals who’ll evaluate every transaction to see if it achieves your desired outcomes. Now, imagine if this team could become the right strategic partner who’ll be able to provide mezzanine funding to supplement the senior debt offering as well.
The good news is it isn’t outside the realm of possibility.
If you’d like to get in touch with a strategic property partner in building sustainable business returns, please email CIB@Nedbank.co.za.
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