Why Mezzanine and Equity Finance are in High Demand

Posted by Brickflow on 2nd October 2024 -

After highlighting an acute equity shortage in last month’s Industry Insights, it’s no surprise that demand for mezzanine and equity finance is on the up amongst property investors. As more borrowers look to plug the gap, now is the time to get to grips with this type of funding.

The Driving Factors:  A Liquidity Crunch and Increased Costs

Across the entire CRE finance market, we estimated a £3bn gap in equity, or in Brickflow terms - a liquidity crunch. This is the additional investment that needs to be made by borrowers each year just to match the number of transactions in the 12 months before the base rate started going up. It's not new or expansion equity. This is standing-still money.  

And from what we hear from our broker partners, it’s posing a significant challenge for property investors.

The liquidity crunch is multifaceted: higher land prices, slower sales cycles tying up capital for longer and whilst lenders are still open for business, they are restricted by how many new loans can be made as existing loans take longer to mature. 

Most significantly though, is higher interest rates amplifying equity requirements. The upward shift of circa 5% in interest rates means borrowers need to pay £50k more per year in interest charges per £1m borrowed. Which equates to £50k extra per million of borrowing in upfront equity to secure the same priced property as a couple of years ago.

The call for more equity, at a time when sales are slow, is a double whammy for property entrepreneurs. Equity is the lifeblood of any property investment company.

To finance the shortfall, property investors could consider:

• Offloading property/sites acquired for future development
• Reducing prices on completed developments to cash out sooner

Those who are determined to avoid fire-sale scenarios, or in fact simply want to use their equity sparingly and smarter, are adding mezzanine and equity finance to their capital stack.

How Do Mezzanine and Equity Work?

Mezzanine Finance

Mezzanine finance slots into the capital stack between senior debt and equity. 

For example, if the main development finance loan covers 70% of the total project costs, rather than contributing 30% in equity, mezzanine debt might plug 20% and enable the borrower to get on site with just a 10% deposit contribution. Typically, mezzanine loans go in on day one, alongside the main borrower's equity.

It’s subordinate, or second-charge, to the senior debt so mezzanine lenders are only repaid after the senior debt lender is repaid in full (but before the borrower can extract any profit). It’s a secured debt, and the senior lender will need to consent to the mezzanine lender being involved. Both will need to agree to an Inter-Creditor Deed (ICD), which governs the rights of each party in the event of default. 

ICD’s can take time to negotiate, which is why working with senior and mezz lenders that have worked together before is normally most efficient, as the ICD will already be in place.

Mezzanine lenders tend to be individuals, family offices or a pool of multiple investors. Some will also have institutional capital, and / or bigger backers; but think asset managers or private equity, who are happy to sit higher up the risk curve, rather than mainstream banks . 

In terms of interest rates, mezzanine finance will carry higher charges than any first-charge borrowing. Rates of between 15% and 25% are typical.

Equity

Equity involves raising capital from an investor to top up the developer’s/borrower’s own capital, normally in return for a pure profit share. Some investors might charge an annual interest rate as well, making it a kind of hybrid debt/equity instrument. 

It’s the peak of the capital stack, so very last to be repaid. However, it’s typical with professional investors in this space to command preferred equity; i.e. to be repaid after all debt and before the borrower. Whereas, the ‘family and friends’ type arrangements, that borrowers may source through their own network, might see investors agree to a pari-passu status (equal footing, no preferred).

Equity investors typically include: 

• Family offices
• Investment professionals
• Private equity firms
• Crowdfunding platforms / P2P (peer-to-peer lending)
• HNWI (high net worth individuals).

In exchange for their stake in the project, equity investors take on some of the risk.

Common equity is typically the initial investment provided by the main borrower and almost all senior debt lenders want to see this ‘skin in the game’.

In terms of the cost of the equity, it is very open to negotiation. 

Equity investment is all about risk. Or, should we say perceived risk. If the scheme has a particularly high profit margin and the main borrower is putting in a decent chunk of their own money, then there are likely to be more investors available and therefore, the cost of the equity falls.

A developer looking for 100% of the deposit from third party investors, is always going to struggle. If a borrower won’t risk their own money on their own project, then why should others? 

Mezz vs. Equity

Whether a property investor is short of equity, or simply prefers to diversify their capital across multiple schemes, both mezzanine and equity finance preserve cash, facilitate further borrowing and potentially enable simultaneous investment elsewhere. As such, they both have similar key benefits:

• Reduces entry capital requirement
• Increases leverage
• Increases Return on Investment (ROI)/ Return on Capital Employed (ROCE)

However, as a second-charge debt, rather than an equity stake, mezzanine finance allows the property developer to maintain full control over the project and its management. Some equity investors may want to have an active role in the project, however, they are more likely to stay in the background, but will insist on controls that they can use if they feel the project isn’t performing.

Both loan types involve a degree of complexity, as it involves working with multiple lenders and multiple legal teams. To make sure deals get over the line, brokers need to understand the intricacies of structured debt, and all parties need to maintain open and transparent communication.

Overall, both forms of financing are playing critical roles in helping investors navigate the changing market dynamics.

Things To Know Before Arranging Second-Charge or Equity Finance

The Lenders

Not all senior debt lenders will be open to borrowers adding a mezzanine layer to the capital stack, so it can be restrictive in terms of who to work with. Likewise, mezzanine finance is often not available to first-time or inexperienced developers. 

Also, most senior lenders will insist on a minimum level of equity from the main borrowers; i.e. they cannot borrow 100% of the deposit. This minimum equity contribution will be project and borrower specific. It’s a point that is often missed by borrowers and intermediaries, but it’s key to know this figure. Otherwise, you’re likely to procure mezzanine finance that isn’t compatible with your senior finance.

To help with this, we have now asked development finance lenders to provide this information on their DIPS in the Brickflow platform.

Another important point is that most mezzanine lenders prefer to sit behind lenders that are deposit-taking banks, or non-banks that are funding by deposit-taking banks. In other words, the majority of each loan is funded via a wholesale funding line supplied by a deposit-taking bank, like RBS or Barclays. The is because in the event the loan goes wrong, mezzanine loan and equity providers trust deposit-taking lenders to act in the best interests of their deposit takers, which normally provides a better outcome for all stakeholders. 

With the property market now ticking along relatively smoothly, bolstered by a positive summer (except weather-wise!), risk/return profiles of new mezzanine loans are very attractive to lenders right now, and those in the space are being compensated with elevated rates at lower leverage levels.

The Costs/Profit Sharing Caution

The cost of mezzanine finance needs to be weighed and balanced against the scheme's viability and profit margins, versus the potential benefits of reducing equity input.

With equity finance, developers can often be too generous with the profit share they agree with the investor. It’s worth remembering that the scheme, and therefore equity investment opportunity, wouldn’t exist without the developer, and the vast majority of the hard work and risk sits with them. The investor is unlikely to be providing a personal guarantee, whereas the main borrower will almost certainly need to. So profit shares agreed with equity investors should be proportionate.

Get Senior Debt First

Whether procuring mezzanine funding, equity or both, having the senior debt arranged first is of paramount importance.

Ultimately, investors or mezzanine providers need to know all the costs (including the funding costs), and exactly how much the borrower needs before they can provide an accurate quote.

It’s likely that as the deal progresses, and costs change, then the amounts of senior, mezz or equity change. But mezz or equity providers need a starting point. A Decision in Principle from a senior lender does that.

Brickflow and Deallocker: A Holistic Solution

Completing the same scheme but with a reduced equity contribution will, logically, increase Return on Capital Employed (ROCE)/ Return on Equity (ROE).

In this worked example by Deallocker, mezzanine finance frees up £1million of borrower equity, and increases ROE by 0.58%. 

Without Mezzanine Finance	With Mezzanine Finance
Purchase price: £10,000,000 Debt: £7,000,000 Equity: £3,000,000 Net Operating Income: £800,000 Debt Service: £525,000 Operating FCF: £275,000 ROE: 9.17%	Purchase price: £10,000,000 Debt: £7,000,000 Mezzanine: £1,000,000 Equity: £2,000,000 Net Operating Income: £800,000 Debt Service: £525,000 Mezzanine debt service: £80,000 Operating FCF: £195,000 ROE: 9.75%

As well as increasing ROE, freeing up cash can help accelerate project timelines, or cover any costly delays, and facilitate simultaneous investment in additional projects, which in turn supports the overall growth of the property sector.
 

Being Cash-Strapped Doesn't Have To Halt Property Investment

At Brickflow we know that equity is the most precious resource to any property developer or investor, and that inefficient equity deployment is the biggest killer of any property business. Yes, it costs money to borrow money, but the opportunity cost caused by equity shortages, or by ploughing all equity into one project, will typically far exceed borrowing costs.

By focusing on smart financing strategies, Brickflow and Deallocker are empowering property professionals to continue driving projects forward, even in a challenging economic landscape.