Mezzanine finance and the risk of 'over-leveraging’ property exposures

As banks tighten lending standards property developers are increasingly faced with a funding shortfall or gap. To fill this funding gap property developers are turning to mezzanine finance. While this is opening-up opportunities for investors to earn higher returns, care still needs to be taken to ensure that mezzanine finance isn’t being utilised to disguise an ‘over leveraging’ of property exposures.

What is Mezzanine Finance?

A mezzanine loan is financing that is hybrid in nature combining the characteristics of both of debt and equity. Typically, its purpose is to fill the gap between the funding provided by the bank or other lenders and any additional costs; i.e. the funding gap. Filling the funding gap is important for property developers as mortgages are restricted by Loan Value Ratios (LVRs) determined by lending institutions and the associated regulatory capital charges. A mezzanine loan can facilitate achieving higher LVRs compared to the materially lower limits set by traditional mortgages. Accordingly, mezzanine finance is used to increase the total debt against the property, above the level that senior lenders are prepared to finance via mortgage finance.

Unlike a mortgage, mezzanine finance is not directly secured by real estate and does not even directly involve land. In the real estate industry, mezzanine financing refers to a loan secured principally by the borrower's equity in other entities. A mezzanine borrower typically only owns limited liability interests in a limited liability company which in turn owns the entity that actually owns the underlying real estate; i.e. it is secured by a pledge of equity interests in an entity that owns real property. Both economically and legally, the value of the mezzanine borrower's collateral derives solely from its indirect ownership of the underlying mortgaged property. Accordingly, a mezzanine loan is not considered a secured loan because it is only secured against the equity in the business. In the event the terms of the loan are not followed then the mezzanine lender can convert their loan into equity comprising either shares, options and/or warrants.

Benefits of Mezzanine Finance

There are several benefits to property developers from utilising mezzanine loans :

Easier and flexible funding : One of the major advantages of mezzanine finance for developers is that they are much easier to acquire than a loan from a traditional bank as it doesn’t require upfront collateral. Private lenders are also able to come up with more flexible terms suited to a developer’s needs compared to a bank loan or mortgage.

The greater level of flexibility is particularly attractive for property developments where the ongoing cash flows of the project may be insufficient to service the mezzanine finance on a cash interest only basis. The more flexible structure allows for the mezzanine loans to be structured to provide the lender with a blend of:

• Cash interest at a fixed or floating rate, paid on a periodic basis.

• Accrued interest, calculated and accrued, but not paid until completion of the project.

• Equity ownership, such as shares (or options to buy shares) in the company that owns the commercial property.

Greater Control : Many private lenders are also happy to pass on more direct equity financing alternatives in favour of higher interest rates with potential equity upside attached so that developers can retain full control at the board level. Furthermore, with mezzanine finance, developers can be cushioned from the effects of the sometimes quick and volatile changes senior lenders apply to the amount of money they lend.

Cost Savings : Another considerable incentive for developers is that although interest rates are higher than traditional loans they are also tax deductible, which means that companies can make greater savings than if they were to part with more equity.

From the lenders perspective the main benefit from mezzanine lending is a higher return which may be more in line with equity while sitting above equity within the capital structure. The higher return may comprise not only higher cash only interest but, depending on the structure, may also include some upside equity optionality. While conceptually mezzanine finance sits above equity the distinction is more relevant when the borrower is ‘a going concern’ and accordingly identifies the priority in terms of accessing cashflows. In default the distinction becomes weaker as the mezzanine loan is effectively converted into equity. Given this many investors view mezzanine finance as being largely equivalent to equity.

Why is Mezzanine Finance Becoming More Important?

There are two main factors which have been driving both a structural and cyclical increase in the funding gap. At the structural level the introduction of Australian Prudential Regulatory Authority’s (‘APRAs’) new capital requirements for Commercial Real Estate lending has reduced the dominance of the major banks. These changes were part of APRA’s response to the Basle III recommendations post the Global Financial Crisis in 2008. The key impact has been APRA’s increase in the risk weights attached for calculating capital requirements for commercial loans especially those with LVRs above 60%; i.e. commercial loans with LVRs above 80% see the risk weighting increase to 110%. The impact on property developers has been to reduce the LVR which banks are prepared to lend up to. The other is more cyclical in nature and reflects that, as interest rates have ‘normalised’, traditional mortgage providers are reducing the LTV ratios on property loans in response to the downward pressure on property values. Associated with the lower risk tolerance of banks is not only lower LVRs but also higher levels of presales being required before a development qualifies for a mortgage. Increasingly banks are requiring 100% pre sales in order for a residential developer to qualify for a mortgage.

Due to these two factors property developers are faced with having to put up greater amounts of their own equity than is preferred or find an alternative source of financing to fill the funding gap. Utilisation of mezzanine finance to fill the funding gap (a) enables developers to preserve more of their equity and (b) assist in lowering the amount of pre-sales needed thereby bringing projects to market sooner than if traditional means of lending needed to be secured.

Care Taken Not to Over Leverage Property Projects

It is here that the investor needs to make the distinction between mezzanine finance being used to fill a funding gap as opposed to being used to over leverage a project. To assist in highlighting the distinction consider two scenarios. The first is where a project would normally support a ‘mortgaged’ LVR of 80%. Due to the banks reducing LVRs they will only provide a secured loan up to 60% which is materially lower than the previous upper limit of 80%. The property developer either adds 20% equity to the deal or finds alternative finance to bridge the LVR or funding gap. This is where the property developer may add 20% mezzanine finance to bridge the funding gap created by changes in the risk tolerance of mortgage finance providers. The total LVR of the project hasn’t changed only the mix of funding has.

The second scenario is basically the same but in this instance the property developer has decided to raise 30% LVR via mezzanine finance.

In this scenario the property developer has utilised mezzanine finance to not just fill the funding gap but also to increase the LVR of the project from the original LVR of 80% to 90%. By doing so the property developer increases the risk that the project may be 'overlevered'.

Why is overleverage a concern?

The risks associated with overleverage can be viewed as occurring at two levels. The first is at the individual project level where there is the increased risk of excessive leverage. At one level it is reasonable to view that over leverage isn’t really an issue provided the mezzanine lenders are being adequately compensated for the additional risk being taken. The risk with mezzanine finance is that being viewed as equivalent to equity the true leverage of the project may be underappreciated. The result is over-confident lenders who over lend at interest rates that do not adequately reflect the hazards inherent in these complicated financings. In effect, this causes a classic market imperfection since there is a mismatch between risks and rewards. This is clearly a greater concern for mezzanine lenders since they bear the risk of default being unsecured lenders. Accordingly, mezzanine investors may be taking on more risk than they bargained for. This is however a risk that needs to be assessed on a ‘case by case’ basis.

The second type of overleverage is where mezzanine debt is utilised to take on LVRs which the investor couldn’t take on via other funding sources. This is particularly relevant with respect to mezzanine finance to property developers as investors may often have separate allocations to property equity. In the event of separate allocations to property equity it is important to ensure that any LVR limits are applied consistently within a portfolio. As an example assume that an investor has internal guidelines which state that when investing in the equity of property deals the LVR cannot exceed 60%. With such guidelines in place then investing in mezzanine debt under either Scenario 1 or 2 would, at the very least, be against the spirit of the investment guidelines even if not an explicit breach. Accordingly, investors need to remain alert to ensuring that mezzanine finance when utilised is consistent with the overall investment guidelines and not as a ‘back door approach’ to adding leverage within a portfolio.

As the funding gap grows in Australia there is likely to be a greater demand for mezzanine finance to provide the additional funds required by property developers. Yet while mezzanine finance can provide higher returns over secured lending its equivalence to equity means that investors should remain wary of falling into the trap of ‘overleverage’. Specifically, investors should ensure that the leverage levels assumed from mezzanine finance are consistent with the overall leverage limits within an investor’s broader guidelines. Failure to do so may result in an investor taking on unintended risks.