The article is part of our series on PDLs and it looks at why property developers need mezzanine finance.
Mezzanine finance provides another level of funding for developers. It is typically a much smaller amount of lending which is used to 'top up' a larger sum provided by a senior lender.
But why is mezzanine finance used, and why don't developers just borrow more from the senior lender? Let's take a look.
Senior lenders charge more
If a property development project is considered by a senior lender (which usually means a bank or a specialist property finance house) to be well planned and considered, with a sound predicted value, then accessing funds is relatively straight forward. The senior lender is likely to be happy to supply the property developer with the funds needed up to a maximum of 60-70% of loan to gross development value (LTGDV). The lending is leveraged against the potential value of the property development, so the lender will always lend less than this total.
The price of the lending, or in other words the interest charged, is calculated based partly on the amount that is being lent. So if a developer wants to borrow 10% of the LTGDV the interest rate will be lower than if they want to borrow 70% of the LTGDV.
It can therefore make sense for developers to split their borrowing between different lenders. The reduced exposure for each lender means the overall interest rate incurred by the borrower may be lower.
Why not borrow the whole amount from a senior lender?
Developers do sometimes borrow all the funding they need from senior lenders, but at other times it makes better financial sense to borrow the majority from one lender and a 'top up' sum (or mezzanine) from another.
Invariably this comes down to mathematics.
For example, if a senior lender is willing to lend a developer £1,000,000 at 9% p.a. interest for one year, this will cost the developer £90,000 in interest every year.
That same senior lender may be prepared to lend the developer £850,000 at 6.5% p.a. interest, which will cost the developer £55,250 in interest every year. They could then borrow the remaining £150,000 from a mezzanine lender at 15% p.a. interest, or in other words at a cost of £22,500. So the total interest cost every year of the finance is £77,750.
This means a saving of £12,250 in interest payments for the property developer.
This is why mezzanine finance can make more financial sense for property developers, and senior lenders are very happy to work with mezzanine lenders because it facilitates a project proceeding and having a better chance of success.
You can find out more about our current PDLs and the rest of the series on PDLs below: