Mezzanine Finance: What is it, how does it work and is it right for me? Here’s our simple guide for smaller developers, advisers and funders.

Next to planning, the biggest obstacle facing SME developers is usually funding.

And even when projects do get underway, smaller firms are held back because they cannot afford to move on to new ventures until their current builds complete.

Mezzanine finance could be the answer.

What is mezzanine finance?

Smaller residential developments depend on a mix of the developer’s own money and a loan, often from a bank.

Mezzanine finance provides another loan on top of the bank’s to reduce the amount of money that you tie up in your project.

It’s called mezzanine because like a mezzanine floor in a building, it’s a midway level. It’s also known as second-tier finance with the first tier being the main bank loan on the project.

Like the bank loan, mezzanine finance is paid for by interest on the loan.

Both bank and mezzanine loans are secured against the property being financed. If anything goes wrong, the bank has first claim on the land and building materials with the mezzanine lender having a second charge.

How does it work?

Let’s say you’re planning to build a property at a cost £1 million (including bank interest) and you plan to sell for £1.2m.

You might borrow £650,000 from the bank including interest. You then have three options to finance the rest.

1. If you fund it yourself, you’ll have £350,000 tied up in the development until it’s built and sold. If it goes for the forecast profit, you’ll make a 57 per cent return on your investment.
2. You could bring in an investor partner, but they’ll usually want a hefty share in the profits.
3. With a £200,000 mezzanine loan, you’ll only have £150,000 of your own money invested. Let’s say the interest on that second-tier loan is £60,000, you’ll still make £140,000 profit, which is a 93 per cent return on your capital.

What does mezzanine finance give you?

• Reduce the amount of money you need to invest yourself.
• Improve your return on investment.
• Increase the number of projects you can take on.
• Diversify the projects you’re working on to reduce your risk.
• Free up funds to pay for up front costs such as conditional contracts, options and planning costs.
• High level funding for projects without losing control or taking on complex joint venture agreements.
• Fixed cost compared with a profit share arrangement.
• Keep all additional profits from better-than-forecast sales.
• Take on larger schemes.

Is it right for me?

Yes, if you want to unlock the benefits and you can meet the conditions.

At Davon, we look for these criteria before we offer a mezzanine loan.

• You’ll need to be an experienced developer with a demonstrable track record.
• Your anticipated profit should ideally be 20 per cent of the cost of the development.
• You’re looking for funding between £100,000 and £3 million per transaction.
• The loan is typically for 12 to 18 months but at least for six months.

Are there any conditions?

• We charge a fee of one per cent of the amount we lend you.
• Interest rates vary depending on each transaction but typically range from 22 to 28 per cent a year.
• Interest is be paid monthly but note that our loans don’t have compound interest on them – you don’t pay interest on the interest.
• You, the developer, must invest a minimum of five per cent of total development costs.
• Planning consent must have been granted for your project.

We also need:

• a formal independent valuation verifying the anticipated sales value
• a clean legal report on the title and other legal aspects
• a project monitor to act for us during the build period
• a deed of priority with the senior debt lender
• personal guarantees if appropriate from the directors of the business
• a fixed and warranted build cost and approved form of build contract appropriate to the scheme
• performance bonds or collateral warranties from the contractor and/or significant professionals appropriate to the scheme.

Frequently Asked Questions

Q. Why is interest on mezzanine finance higher than bank interest?

A. Interest on mezzanine is at a higher rate than on the senior debt due to the higher level of gearing and therefore greater associated risk.

Q. How am I better off using mezzanine finance than giving a partner investor a share of the profits from my project?

A. The benefits of using mezzanine over an equity partner are that it allows you as the developer to retain complete management control of their project while hugely reducing the amount of funds you have invested and substantially increasing your return on your equity. It also allows to spread capital across a number of projects instead of being fully invested in one scheme which spreads your risk and supports your business growth.

Q. At what point in the project can we bring in mezzanine finance? We are open to introducing mezzanine to schemes not just ahead of the start on site but part way through the build, which can release part of your equity to invest in new schemes or to cover unforeseen circumstances.