Mezzanine Finance: Unlocking Higher LTV Deals

Mezzanine finance is a powerful tool that enables property developers to achieve higher loan-to-value (LTV) ratios, reduce equity requirements, and unlock deals that would otherwise be unfeasible. Understanding when and how to use mezzanine finance can significantly accelerate your development business.

What is Mezzanine Finance?

Mezzanine finance sits between senior debt (the primary loan) and equity. It's a subordinated debt facility that ranks behind the senior lender in the capital structure but ahead of equity holders.

Capital Stack Structure

1. Senior Debt: 60-70% LTV - lowest risk, lowest return
2. Mezzanine Debt: 10-20% additional LTV - medium risk, medium return
3. Equity: 15-30% - highest risk, highest return

By combining senior and mezzanine debt, developers can achieve total debt financing of 75-90% LTV, significantly reducing equity requirements.

How Mezzanine Finance Works

Mezzanine finance is typically structured as:

Security Position

**Second charge** behind the senior lender - if the project fails, the senior lender is repaid first from any sale proceeds. The mezzanine lender only receives payment after the senior debt is satisfied.

This subordinated position means higher risk, resulting in higher interest rates.

Interest Rates

Mezzanine finance is more expensive than senior debt:

• Senior debt: 6-9% per annum typically
• Mezzanine debt: 12-18%+ per annum

The higher rate reflects the increased risk of the subordinated position.

Typical Terms

• Duration: Aligned with senior debt, typically 12-24 months
• Interest: Usually rolled up (added to loan, paid on exit)
• Arrangement fees: 2-3% of facility
• Exit fees: Sometimes charged, 1-2% of facility

When to Use Mezzanine Finance

Mezzanine finance is appropriate in several scenarios:

Limited Equity Available

You've identified an excellent opportunity but lack sufficient equity for traditional 30-35% deposit requirements.

**Example**: £2m development project

• Senior debt at 65% LTV: £1.3m
• Required equity (35%): £700,000
• Available equity: £400,000
• Mezzanine finance: £300,000 (15% LTV)

Mezzanine fills the £300k gap, enabling the deal to proceed.

Maximizing ROI

By reducing equity contribution, you can improve return on equity, even accounting for mezzanine costs.

Multiple Concurrent Projects

Developers with several projects running simultaneously can use mezzanine finance to spread equity across more deals.

JV Equity Replacement

Rather than bringing in equity partners (who typically expect 20-30%+ returns), mezzanine debt at 15% might be more cost-effective while maintaining control.

Speed and Flexibility

Mezzanine lenders can move faster than equity investors and impose fewer operational controls.

Mezzanine Finance Example

Let's analyze a development deal with and without mezzanine finance:

Scenario: £3m Development Project

**Costs**:

• Land: £1m
• Build costs: £1.5m
• Finance costs: £250k
• Professional fees: £150k
• Contingency: £100k
• Total costs: £3m

**GDV** (Gross Development Value): £4.2m **Projected profit**: £1.2m (before finance costs)

Option A: Senior Debt Only (65% LTV)

**Senior debt** (65% of £4.2m GDV): £2.73m **Your equity required**: £3m - £2.73m = £270k

**Senior debt cost** (8% per annum, 18 months):

• £2.73m x 8% x 1.5 = £327,600
• Plus 2% arrangement fee: £54,600
• Total senior cost: £382,200

**Net profit**: £1,200,000 - £382,200 = £817,800 **Return on equity**: £817,800 / £270,000 = 303% (over 18 months) **Annualized ROI**: ~202%

Option B: Senior Debt + Mezzanine (80% LTV total)

**Senior debt** (65% of GDV): £2.73m **Mezzanine** (15% of GDV): £630k **Your equity required**: £3m - £3.36m = None (actually receive £360k excess)

Adjusted structure:

• Land: £1m (70% senior, 30% mezz)
• Build: £1.5m (100% senior)
• Senior debt: £2.2m
• Mezzanine: £450k
• Your equity: £350k

**Senior debt cost** (8%, 18 months):

• Interest: £2.2m x 8% x 1.5 = £264,000
• Arrangement: £2.2m x 2% = £44,000
• Total: £308,000

**Mezzanine cost** (15%, 18 months):

• Interest: £450k x 15% x 1.5 = £101,250
• Arrangement: £450k x 2.5% = £11,250
• Total: £112,500

**Total debt costs**: £420,500

**Net profit**: £1,200,000 - £420,500 = £779,500 **Return on equity**: £779,500 / £350,000 = 223% (over 18 months) **Annualized ROI**: ~148%

Comparison

**Without mezzanine**:

• Equity required: £270k
• Profit: £817,800
• ROE: 303%

**With mezzanine**:

• Equity required: £350k
• Profit: £779,500
• ROE: 223%

While ROE is lower with mezzanine, you preserve £80k equity for other investments. If you can deploy that £80k elsewhere at reasonable returns, overall portfolio returns may be higher.

Benefits of Mezzanine Finance

Reduced Equity Requirements

Lower deposit requirements enable participation in larger deals or multiple concurrent projects.

Maintain Control

Unlike equity investors, mezzanine lenders don't take ownership stakes or require board representation.

Leverage Experience

Experienced developers can use mezzanine to scale operations faster than equity accumulation allows.

Flexible Structures

Mezzanine terms can be tailored to specific project requirements.

Speed

Mezzanine lenders can often complete due diligence and documentation faster than equity investors.

Risks and Considerations

Higher Interest Costs

Mezzanine rates of 12-18%+ significantly increase project costs. Margins must be sufficient to absorb these costs.

Increased Leverage Risk

Higher overall leverage means less cushion if things go wrong. If GDV falls or costs overrun, higher leverage amplifies losses.

Complex Documentation

Mezzanine agreements are complex, requiring experienced legal advice. Ensure you understand all terms and covenants.

Intercreditor Agreements

Senior and mezzanine lenders must agree on their relationship through intercreditor agreements. These dictate what happens if the project faces difficulties.

Limited Flexibility

Once committed, mezzanine terms can be inflexible. Early exit may trigger significant fees.

Lender Requirements

Mezzanine lenders typically require:

Developer Experience

• Proven track record of completed projects
• Demonstrated experience with similar-sized developments
• History of delivering on time and on budget

Project Quality

• Strong GDV evidence from professional valuation
• Detailed, realistic cost projections
• Experienced contractor and professional team
• Planning permission in place
• Proven demand for end product

Financial Strength

• Some equity contribution (rarely 100% debt)
• Financial capacity to cover contingencies
• Strong personal financial position

Clear Exit Strategy

• Credible plan for loan repayment
• Pre-sales or forward funding where possible
• Alternative exit routes identified

Senior Lender Consent

Crucially, **senior lenders must consent** to mezzanine finance. The intercreditor agreement defines:

• Mezzanine lender's rights
• Senior lender's priority position
• Standstill periods (mezzanine can't enforce during certain periods)
• Notification requirements
• What happens in default scenarios

Some senior lenders refuse to allow mezzanine debt, viewing it as increasing project risk.

Alternatives to Mezzanine Finance

Equity Investors/JV Partners

Bring in partners to provide equity:

• Pros: Aligned interests, share risk, no interest costs
• Cons: Give up profit share and control

Preferred Equity

Structured between mezzanine and equity:

• Pros: More flexible than debt
• Cons: More expensive than mezzanine

Higher-LTV Senior Debt

Some specialist lenders offer up to 75-80% LTV senior debt:

• Pros: Simpler structure, one lender relationship
• Cons: Higher senior debt rates, stricter terms

Stretched Senior Debt

Negotiate higher LTV with senior lender:

• Pros: No second lender, simpler documentation
• Cons: Not always available, may require guarantees

Structuring Mezzanine Deals

Phased Drawdown

Structure mezzanine to draw only when needed, minimizing interest costs.

Profit Share Options

Some mezzanine lenders offer lower rates in exchange for profit participation.

Convertible Terms

Mezzanine that converts to equity under certain conditions.

Cost Averaging

Combine multiple mezzanine sources at different rates to optimize blended cost.

Due Diligence on Mezzanine Lenders

Not all mezzanine providers are equal:

Track Record

Research lender's history:

• Years operating
• Projects funded
• Reputation in market

Terms Clarity

Ensure full understanding of:

• Interest calculations
• Fee structures
• Early repayment terms
• Default provisions

Speed and Reliability

Can they deliver funding on time? Delays can destroy development deals.

Expertise

Do they understand property development? Experienced lenders add value beyond capital.

When NOT to Use Mezzanine Finance

Tight Margins

If project margins don't comfortably absorb 15%+ mezzanine costs, don't use it.

First Development

Most mezzanine lenders won't fund first-time developers. Build experience with traditional structures first.

Weak Projects

Mezzanine can't save poor deals. It should enhance good projects, not rescue bad ones.

Alternative Options Available

If you can raise equity at reasonable cost or secure higher-LTV senior debt, mezzanine may be unnecessary.

Conclusion

Mezzanine finance is a sophisticated tool that enables experienced developers to achieve higher leverage, preserve equity, and scale operations faster. When used appropriately on strong projects with sufficient margins, mezzanine finance can significantly enhance returns and enable deals that would otherwise be impossible.

However, the higher costs and increased complexity mean mezzanine isn't suitable for every project or every developer. Success requires careful analysis, experienced professional advice, and realistic assessment of project margins and risks.

For developers ready to scale their operations and tackle larger projects, mezzanine finance offers a powerful way to unlock higher-LTV deals while maintaining control and maximizing equity efficiency across their portfolio.