Introduction
During periods of uncertainty, developers will need to review and potentially alter their overall strategy – especially when it comes to their financial position. Developers should acquire further knowledge on the various financial products on offer to ensure they are in the best possible position and this blog post addresses this to some extent.
Developers will tend to have a formalised process when it comes to securing funding for their projects however, opportunities can still be missed. It is also the case that a general lack of awareness of how debt can actually be structured can lead to missed opportunities.
When developers want to take a higher risk to protect their cashflow and overlap different build programmes, they need different types of finance in order to stretch their gearing. The types of finance used in this scenario include stretched senior finance and mezzanine finance. In this blog post, I first define each type of finance and later in the post, outline how each type can be structured.
Stretched Senior Finance
A stretched senior loan is a product offered by lenders in order to increase their regular senior debt loan. An example of this would be a maxed out senior debt loan at 60% LTGDV and then using a stretched senior debt product to deliver a 70% LTGDV.
Mezzanine Finance
Mezzanine finance cures the same need. Mezzanine is a way of bridging the gap between senior lender finance and the developer’s equity. Mezzanine finance is normally secured by having a second charge over the development in question, whilst the bank or senior lender hold a first charge.
In future blog posts, I will go on to explore additional ways that debt can be structured for development projects.
Part 1a) Funding a development project using stretched senior finance vs. using a combination of senior + mezzanine finance
What are the upsides to simply using stretched senior finance?
For the borrower, stretched senior finance provides speed, convenience and cost savings. The borrower does not have to negotiate separately with two different lenders and saves cost by having just the one set of legal documents.
What are the downsides to using stretched senior finance?
Although dealing with one lender to stretch their offering can be a simpler process, it may not be the best way to achieve the highest return on equity. This is where the role of a financial advisor comes into play, as they can evaluate the benefit of using a stretched senior product - in terms of return on equity, vs. the use of mezzanine finance alongside senior debt, which may prove to be a better option.
Stretched senior products are usually structured on a fixed rate return basis, thus meaning the borrower has to pay a higher interest rate across the entire loan. Whereas senior finance can be structured on a lower variable rate - which depending on the project and the senior loan leverage, can lead to a large saving for the client. The senior loan is combined with mezzanine finance and will be on a fixed interest rate basis.
Part 1b) Funding a development project using senior + mezzanine finance
What are the upsides to using senior + mezzanine finance?
By using senior and mezzanine finance, a blended interest rate can be calculated and this creates an average interest rate between the senior and the mezzanine interest rates. This can give a developer a competitive pricing edge in comparison to using a stretched senior product. There is of course the need to assess the overall total cost of funding which includes the interest rate, arrangement fees and legal fees.
By using mezzanine finance instead of a stretched senior product, the developer is potentially able to achieve a higher gearing level which means a higher level of costs being covered and a smaller amount of equity required upfront.
Mezzanine finance broadens your funding market as we are able to work with many more senior lenders and this gives a developer a lot more lenders to approach in order to secure the right funding package.
What are the downsides to using senior + mezzanine finance?
This route is slightly more complex as there are two different lenders to deal with, as well as legal requirements and costs. This can be a deterrent to this route, but the longer-term added value can make it a lot more profitable.
The perception of mezzanine finance is that it is expensive, but an advisor needs to demonstrate to the client the overall funding cost including senior debt and professional fees . The debt advisor also needs to be competent in advising and negotiating with both the senior and mezzanine finance providers. There is a risk that the two lenders will not be able to negotiate and agree the Inter Credit Deed between them, so it is important for an advisor to address this at the earliest possible stage or even to ask if the two lenders have a pre agreed document they have used on previous cases.
Coming Up: Part 2 – Interest on development finance: fixed rates vs. compounding interest
If you would like to speak to myself or any of the team about a development finance requirement, please contact me by email: tom.berry@arcandco.com or phone: +44 (0) 20 3205 2192