Using Mezzanine Finance to Save Your Project from Profit Destroying Cost Overruns

Property development is a complex and capital-intensive process, and cost overruns are a common challenge that developers must navigate. A surge in construction costs has been particularly evident over the last 12 months due to supply chain issues and labour shortages. Even during more stable climates, cost overruns can occur for various reasons, such as unexpected site conditions, changes in building codes, or delays in obtaining necessary approvals. If not appropriately addressed, cost overruns can cause problems with the builder and their trades, potentially putting senior loans into default and ultimately placing a development project at risk.

In such a scenario, Mezzanine Finance can provide a pathway for getting your project back on track and fully funded. Mezzanine Finance is a type of capital that sits between senior debt and equity in a capital structure and is usually repaid at the end of a project after the senior funder is paid in full.

Mezzanine financing is a more expensive form of capital than traditional debt, as the lender will expect a higher return on their investment, but we have seen this form of funding used consistently by very successful developers to shore up their projects and protect their return on capital. With the right structure and lender, mezzanine finance can be a powerful tool for developers.

Here are some of the factors to take into account when looking at obtaining Mezzanine Finance to cover cost overruns mid-project:

Interest rate and fees: 

Mezzanine Finance is generally more expensive than traditional debt, as the lender will expect a higher return on their investment given the higher risk they are taking. Developers should be aware of the interest rate and associated fees, such as origination and legal fees, and factor these into their overall project budget and returns. In scenarios where the developer has the capital to fund the cost overruns or at least a portion of them, a commercial decision will need to be made as to the benefits of this type of financing, although many successful developers will favour preserving their capital for the next opportunity where possible.  

Senior Funder Cooperation: 

Arranging a mezzanine loan will always require the consent of the senior funder, who will usually need to enter into a priority deed with the mezzanine lender so that the order of repayments at the end of the project is agreed to upfront. It is important to obtain the cooperation of the senior funder as early as possible in the process and work through the potential terms of the priority deed and how the legal documentation will work to avoid delays and issues down the track.

Exit strategy:  

Developers should have a clear exit strategy in place to repay the loan when it comes due. For most projects, this will usually be through sales at the end of the project, but in cases where sales will not fully repay the debt, alternative repayment strategies need to be put in place and made as clear as possible during the loan submission. This may include taking out a residual stock loan, completing more sales or potentially one of the funders paying out the other. Having a clear understanding between lenders and developers as to how the repayments will work when settlements occur at the completion of the project will help avoid costly settlement delays at the end of the project. The last thing a developer wants is for settlements to fall over due to disagreements over repayment amounts or lack of communication.

Loan Covenants: 

Senior development loans will usually have covenants with respect to areas such as Loan Value Ratio (LVR), sales, and borrower equity. It is important to ensure that none of these covenants are breached by the terms of the mezzanine loan, as such breaches can result in penalties or, in the worst case, trigger the senior funder to withhold further payments. The mezzanine loan may also have covenants to

Relationships are Key: 

A high level of trust is required between lenders and developers to successfully execute these transactions, given the high stakes and risks being taken by all parties. It is advisable for developers to be as transparent as possible and look to build trust with the lenders while also ensuring that they are working with trusted parties. This can be achieved by researching lenders or dealing with loan originators who are experienced with these transactions and can guide you along the way.

Get Proper Legal Advice:  

With multiple parties involved in these transactions, each with their own competing priorities, it is essential that you have your own legal counsel to make sure the documentation is fair and reasonable and that there is good coordination between the legal consultants acting for the lenders. Given the complexities of these transactions, it is essential to deal with a solicitor who is experienced with property deals so that you can make informed decisions with regard to the signing of documents and, where required, negotiate on terms to ensure a good outcome.  

By taking these factors into account, developers can make informed decisions about mezzanine finance and use it effectively to meet the capital needs of their property development projects.