Over the years, I’ve had countless conversations with people about Mezzanine debt (2nd mortgages), Preferential Equity and Joint Ventures in property projects. I’ve heard opinions and seen situations across the full spectrum, such as:
- The Good: “I couldn’t have got myself to where I am today without it.”
- The Bad: “Our site was repossessed and sold at a lower value than the total debt.”
- The Ugly: “The Mezz/Pref lender wants you to fail, so that you lose your equity and they can take the property for themselves.”
It’s understandable that people are pretty confused. So, what’s the truth about Mezzanine, Preferential Equity and Joint Ventures? If you are going to choose one, which is the better structure?
Before we delve too much further, let’s look at what they are, how much they cost, and some of the specific pros and cons of each:
|Mezzanine Debt||Preferential Equity||Joint Venture|
|What is it?||2nd mortgage behind the Senior Debt (the 1 st mortgagee)||Hybrid of debt and equity, taking on characteristics of either or both, but being in preference to the Ordinary Equity (e.g the shareholders)||Usually “ordinary equity” on a “shoulder to shoulder” basis, i.e. you and I put our money in together, we win and lose together|
|How much does it cost?||Usually a fixed interest rate anywhere between 15% and 30%||Can vary significantly, ranging from a fixed interest rate, to a profit share, or a blend of both||Share of profit, relative to each party’s shareholding|
|What security is taken?||2nd mortgageOther usual securities similar to the 1st mortgagee’s||Can vary significantly||Usually just the JV agreement|
|Common Pros||Less of your own equity = diversification across multiple projects and better Return on Equity (less profit per project, but more profit overall)Potentially able to start a project sooner by having less Senior Debt (but then maybe not, if the lender wants the pre-sales!)Using a quality partner can deliver tangible value through their experience and capability|
|Specific Pros||Usually the cheapest capital compared to Pref & JV||Banks can be more ok with Pref than MezzWill often lend to a higher LVR than Mezz||Real equity preferred by BanksProject delays don’t eat away profitsShare the risk with another party|
|Common Cons||High interest rates brought in too early can eat away your equitySwimming with [loan-]sharks can be deadly|
|Specific Cons||Banks often don’t like Mezz, if they do they will usually cap the LVRSome non-banks also don’t like it (but some don’t care)||Securities can give the lender wide ranging powers, including “take-over rights”||Usually THE most expensive capitalHave to share decisions with someone else|
One of the biggest reasons people shy away from these kinds of financing arrangements is because they’re often associated with taking on too much risk, i.e. property developers who are trying to do projects that are bigger than what they can handle. Sometimes this can be the case. Having said that, there’s often more to it. Other instances in which high leverage may be undesirable (or unsuitable) – particularly that structured as debt – can include:
- Loading the project with too much debt pre-construction (i.e. on the site), leaving not enough equity to actually step into construction. Too much debt too early in the project (particularly pre-construction) puts you at risk of having no equity, or even negative equity if your site value drops (and that HAS happened in many cycles – FYI, development sites are typically THE most volatile property asset type).
- Banks, and even non-banks, usually expect to see some level of equity (how much exactly can vary wildly), so loading up on Mezzanine Debt on the assumption that it won’t get any attention paid to it by the 1st mortgagee can be akin to having your head in the sand.
- Some of the largest and most successful developers stay well clear of it, having lots of equity in all of their projects.
However, there are scenarios where high leverage can be a good strategy. In fact, some of the largest and most successful developers thrive on it (yes, I know that I did say exactly the opposite in the last line!), spreading their equity across more projects – generating less profit per project, but more profit across a portfolio or pipeline (Return on Equity being key, as opposed to the capital-blind metric, Return on Cost).
Furthermore, there’s an argument that overall portfolio risk can actually be reduced by increasing leverage – based upon simple diversification theory (if you put $100 into 1 project and that project goes bad, you lose everything; if you put $100 into 10 projects, if 3 of your projects go bad, you’ve only lost 30% of your money).
All in all, used in the right quantity, at the right time, from a quality and trustworthy capital partner, it can very much present an acceptable risk.
Considering your options?
Ok, so you’re thinking about using someone else’s money, to some degree, at some time. What are the critical factors that need to be considered? When we’re considering capital strategy, some of the key factors we look at include:
- Timing – load up on expensive money too soon and it will “chew its own head off”. However, doing so can be fine, provided that you have a reliable way to get it under control before construction, e.g. from sale proceeds of another project that will be finished before this one starts.
- Quantity – too much debt can cripple you and eat away your profits; conversely, putting little to no equity in a project can result in an infinite Return on Equity. Be clear about your logic behind how much you’re taking on.
- Terms – “the devil is in the detail”. Promises of cheap interest rates are often loaded high management fees, admin fees, exit fees, extension fees, etc. A loan term of 12 months, when you have no chance of repaying until at least month 14, is likely to come with [what can be high] extension fees. Less obvious can be factors such as what constitutes an Event of Default and how long a remedy period you have.
- Who are the capital partners (who you are getting into bed with?!). Getting it done ASAP, rather than taking the time to find the right partner, could prove to be a very expensive and painful mistake later on. There are some true sharks swimming in the 2nd mortgage space; and don’t think that a JV will be much better, we’ve seen very painful JVs resulting in years in court fighting out disputes. Stick with professionals that have a vested interest in seeing you complete your project successfully, not ones that would prefer to see you fail.
Providing Professional Capital Advice is What We Do!
Understanding and navigating the complex world of project financing is complicated and fraught with risks. Strategising, analysing and negotiating the right funding model for your business or project is what we do every day.
Whether that’s Mezzanine Debt, Preferential Equity, or a Joint Venture partnership, we provide independent advisory services to help you weigh up your options. We have solid relationships with high-quality capital partners, including Fund Managers and Ultra-High Net Worth Individuals. Importantly, we pride ourselves in dealing only with trustworthy & reliable funders and investors (no need to be beware of Gold Coast sharks here!).