Mezzanine Capital Is More Relevant For Real Estate Transactions: What Developers Should Know
Real estate developers continue to look for solutions to increase the return on their investments. In recent years, we observed a spike in alternative financing possibilities in contrast with traditional senior loans. Why is it so attractive for real estate developers to go for substitute financing tools, and what do they need to know going in?
Within the real estate sector, maximum senior debt doesn’t tend to cross the 80% mark, leaving investors with a visible gap. Luckily, there are now several additional options other than banks and pure equity to invest in real estate ventures. Among those alternatives, we have Bridge, Mezzanine, and Whole Loan financing, which is a mix of Bank and Mezzanine Financing with a relatively low blended rate between 4,5% and 8% depending on the project.
We have previously discussed several beneficial aspects of the Mezzanine capital. It is an incredible option for those who feel uneasy about bridging the gap on their own. While on the one hand, the interest rate gets higher, so does the return. The repayment period is also shorter, typically one to three years. And when the investment is structured as a hybrid of equity and debt, the investor will have a portion of equity as a shield from the owner’s default.
Now, let’s crunch some numbers to observe the numerical expression of benefitting from Mezzanine financing.
Mezzanine Financing in Action
Let’s assume a developer has €5M cash equity to invest in real estate projects. If one project has a total GIC of €25M and assuming an 80% leverage from a senior bank, the developers need to put all their money in one project.
From the past data, we have noticed that the development yield (Profit/GIC) on average lies somewhere between 15% and 25%. For the sake of this demonstration, let us assume a development yield of 17.5%. This gives a total profit of €4.4M. As a result, in three years, the developer will be able to earn back the initial investment and gain a profit of €4.4M.
Assuming the developer goes for Mezzanine financing, there is an option to do more than just one project. If the developer leaves 5% of the total capital structure as equity, this means they would only leave €1.25M in each project. Going back to our initial scenario where the developer had €5M cash available, there is a potential to do three more projects at €1.25M equity each. And the rest will be financed via Mezzanine.
Using our previous assumption of 17.5% development yield, a GIC of €25M per project, and an average interest rate for the mezzanine capital of 16% yearly (this rate can be lower or higher depending on the type of real estate project.) We are only using a high number to illustrate how lucrative a project can still be with a high-interest rate. In conclusion, the developer can achieve a higher cash-on-cash multiple on the investment, leaving 60% of profit per project in the pocket and paying 40% to the Mezzanine investor. The difference between committing to one project versus three projects is drastic. Here is what it will look like in summary:
From this example, we can see that the developer can quadruple the invested amount and significantly increase the return. This way, the Mezzanine solution is better than including an equity partner who can take up to 80% of total profit depending on their return profile (i.e., hurdle rate and lower promotion for developer). However, as the potential gain increases, the risks do as well. Therefore, there are several factors for the developer to keep in mind when considering Mezzanine financing.
Addressing the Mezzanine Capital Risks
It makes perfect sense to take a Mezzanine investor on board when there is more than one project from the return perspective. However, there is a possible downside if:
The project takes longer than expected (due to a permitting delay, for instance)
Project sales are not matching the initial target
Project costs are higher than planned (i.e., rise in construction costs)
All three of the above can turn the project around and visibly diminish the return. The interest rate is a fixed component, which means it has to be paid no matter the project’s negative impact. To mitigate such a risk, the developer always needs to assume the following worst-case scenarios before considering a Mezzanine investor on board:
Calculate the interest period one year more than planned
Simulate the return if:
Project costs increase by at least 5%
Projected sales are 5% less than planned
If, after such assumptions, the marginal profit is at least 30%/70% (Developer/Investor), it is still a good idea to take a Mezzanine partner into the project.
Real Estate Investment Opportunity MeetUp
On February 17, 2021, Fonto Capital and Grammig Advisory invite you to join a virtual investors meetup, where you will learn about structured financing solutions for real estate projects as an alternative investment opportunity to diversify your portfolio. Use the link below to register early. See you there!
Investment Opportunity: Real Estate Financing Investor MeetUp
17 February 2021 – 16:00 CET
Registration Link: https://bit.ly/2L4M6Oz