Mezzanine Finance, Mezzanine Debt – or ‘Mezz Debt’ for brevity’s sake – is a term on the rise in the construction and development world. But it’s a term that a lot of us are unfamiliar with. So, let’s talk about it.
What exactly is Mezz Debt? And how can it be a game-changer for your next construction project?
The easiest way to think about Mezz Debt in relation to construction loans is as a ‘Capital Stack’, a term commonly used to describe the various levels of capital that join forces to fund a project. Personally, the idea of a Capital Stack makes me think of a juicy burger, so here goes nothing – my construction financing hamburger analogy, The Capital Stack.
First off, we have our burger bun – the Senior Debt. That’s the most substantial part of the Capital Stack, and it makes up much of the Loan to Value ratio of a project. If you’re securing this Senior Debt from a private lender, then it usually sits at between 67 and 75 per cent of the Total Development cost, according to HoldenCAPITAL Director, Dan Holden. The Senior Debt, the construction loan, is our bun, holding the Capital Stack burger together.
What we have left in our Capital Stack are the patty and the toppings – this is the outstanding capital required to get the project off the ground. The Senior Debt provider, or the primary lender, won’t provide all the ingredients for the Capital Stack. They need to see that the borrower has enough ‘skin in the game’ to make the project viable. It doesn’t matter what the projected value of a construction project is, or how delicious that burger sounds on the menu, the Senior Debt provider just won’t bite if the borrower’s risk capital isn’t there.
Without our patty – be it Wagyu, fried chicken, or lentils masquerading as beef – all we really have is two soggy pieces of bread. And nobody wants that. So, what does the borrower do if they don’t have enough equity for the capital risk? What if there isn’t enough up-front cash for the deposit? Let’s put our Capital Stack into the perspective of a real-world example and see.
Chris, one of Archer Private’s borrowers, was buying land in Adelaide for $1million, with an estimated $1.6 million value after subdivision. To undergo the project, Chris needed a loan to settle the purchase, and our private lender provided a loan of $700k. The Senior Debt was sorted at a 70% loan to value ratio (LVR).
But, Chris had already spent $200k of his own funds to get through government red tape with the necessary approvals and permits, so he needed additional help to make up the remainder of the project costs. That’s where we look to Mezz Debt in our Capital Stack.
If the borrower can’t put up all the up-front cash needed to get the primary loan over the line, Mezzanine Debt can be a terrific solution. With Mezz Debt in our Capital Stack, the Loan to Value ratio increases for borrowers like Chris, who now only need to contribute a small portion of their own money to fund the project.
In this case, Archer Private’s Mezz Debt partner provided the additional $300k Chris needed on top of the primary lender’s $700k, amounting to the $1million required to purchase the land or 100% loan to value ratio (LVR).
Looking back at our Capital Stack, we see that all the borrower needs to bring to the table are a few toppings. These can be as simple as some ketchup, or as substantial as a classic Aussie burger with the lot. It’s up to the borrower how much of their own equity they can and want to add to the Capital Stack, but most of the funding is covered by our Senior and Junior Debt – our construction loan and Mezz Debt.
After Chris purchased the land with the $700k provided by the private lender’s construction loan and the $300k of Mezz Debt, all he needed to fund himself was the subdivision of the land. The end value was a fantastic $1.6 million after project completion. In this, we can see how the borrower leverages their potential return, while simultaneously minimizing the amount of capital they must dedicate to the transaction. According to finance writer Jordan Wathen, this maximizing and minimizing dichotomy is why Mezzanine Debt sits somewhere between traditional debt and equity. Chris paid the Mezz Debt back within 6 months, having sold enough blocks to cover the cost within the loan term.
If you have a construction project on the horizon and want to minimise your dedicated capital, whilst at the same time upping the viability of your project, Mezz Debt can be a great solution. It’s worth sitting down and looking at how your own Capital Stack could add up to one delicious combination of a primary loan and Mezz Debt. If you need advice, feel free to contact us at Archer Private!