More and more we are reading about Mezzanine Finance in the construction finance sector, but what exactly is Mezz Debt?

Firstly, let’s look at the technical side of this type of finance as it is applied in the development arena. In banking terms, it simply refers to a subordinated debt piece that is usually secured by a second ranking registered mortgage over the relevant development property. The subordinated reference simply acknowledges the fact that as a second ranking debt, the Mezzanine lender has acknowledges the rights and entitlements of the first ranking lender to recover their debt under a priority arrangement relating to the security. It should be noted that not all Senior Lenders will agree to a subordinated debt position, more of that later.

So, by definition Mezz Finance also referred to as Junior Debt, sits between the Senior Debt and the Developer’s equity in what is often referred to as the “Capital Stack”, a commonly used term describing the various levels of capital used to fund a Project. 

In practical terms, a Mezz debt is an extension of debt beyond the Loan to Value Ratio levels that a senior lender is typically willing to provide. In today’s market, this is usually beyond 67-75% of the Total Development Cost or “TDC” of the project in question. 

A Mezz Lender will typically be prepared to advance up to around 90%+ of the TDC with the remaining 10% considered to be the project equity which the developer is required to contribute as their “skin in the game” or risk capital. So an example of a typical Mezz debt project structure might look something like this:

Project Capital Stack

Developer Equity: $10M

Mezzanine Debt capped at 80% TDC: $15M

Senior Debt capped at 75% TDD: $75M

Total Project Development Cost: $100M

The obvious attraction to a developer is the ability to leverage his capital and utilise the $15M in funds that he would otherwise have had to commit to the project to better effect, possibly the securing of his next project site. Mezz debt can typically be found at a cost of 18-26% per annum depending on the levels of risk being taken so provided the developer can use his capital to better effect from a return on capital perspective, Mezz debt can be a useful tool.

In order to secure a Mezzanine Debt piece, the developer will be required to have de-risked the project as much as possible. Normally this style of loan/investment does not occur until the project is “shovel-ready”. If the debt is required prior to this status being achieved, it is typically viewed as equity rather than an extension of project. Mezz debt is readily available for shovel-ready projects where the developer has demonstrated they have minimised the project risks, such as presales, final construction costings being contracted and the senior debt being fully approved. 

So where can a developer source Mezzanine debt? There are many options in the market place ranging from various funds to private lenders prepared to take the extra level of risk in order to earn a more attractive level of return on their investor funds or capital. However, the real challenge is not so much finding sources of Mezzanine debt, but rather, being able to secure it at an appropriate price and on terms that are not onerous if the project comes under pressure down the track. 

The ability to navigate those negotiations as well as those required with the senior Debt Lender to gain their acceptance of the Mezz piece can be tricky and a developer would be wise to ensure that they have experienced advisers and legal support to guide them through the process and ensure that they have the appropriate protections under the various agreements which are involved in the process.

To summarise, Mezzanine debt can provide a developer with a significant edge and an ability to get the most out of his capital resources, however he needs to understand the risks involved, know when its appropriate to use it and negotiate appropriate terms to ensure the risk return equation properly reflects his appetite. 

This article was written by Dan Holden of HoldenCAPITAL, a bespoke construction finance firm. HoldenCAPITAL arranges construction finance and invests in projects through their equity trust, Queen Street INVEST. To discuss your project finance requirement please call (07) 3171 4200 or visit www.holdencapital.com.au.

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