The Banks — cause and effect. Currently many mainstream banks that provide finance to property developers are seeking loan to value ratios of 55% to 65% and loan to cost ratios of 60% to 75%, often leaving developers with sizeable gaps in their finance requirements.

For investors, banks are offering unattractively low interest rates on deposits and the acrobatics of the share market have caused many with liquid assets to seek other investments. With mezzanine finance rates running at between 16% to 30% per annum, this has resulted in many wealthy investors turning their hand to providing mezzanine finance to property developers to fund their shortfall in bank finance.

Supply meets demand: everyone’s a winner — or are they?

The success of the relationship between the mezzanine lender and the property developer, and indeed the underlying property development, is often dictated by the manner in which the relationship is documented at the outset of the relationship. Due to the nature of mezzanine finance, it is often required quickly and without the benefit of a leisurely examination of either the development project or the mezzanine finance documentation. This can lead to a ‘she’ll be right’ attitude being adopted by one or more of the parties. Where the development proceeds as planned and the lender receives all that they are owed, everybody is happy. However, life does not always go to plan and problems can, and do, arise.

Considerations

While it is not possible to identify here all risks and potential issues, the following should be kept in mind by those who may be thinking about obtaining or advancing mezzanine finance.

Developer’s considerations

  • Will the existing/senior lender object? The terms and conditions under which most banks advance money to developers usually prevent the developer from borrowing any more money without the bank’s consent. Failure to obtain consent before borrowing additional money can be an event of default entitling the bank to take enforcement action under its security or refuse to advance further money under a current facility. It is therefore important to identify what the existing bank’s attitude is to mezzanine finance.
  • Will the project support the cost of the finance being offered? It is important to identify the total cost of the finance. Whilst the interest rate being charged may be obvious, it is often the case that additional arrangement fees, legal fees and management fees are charged, resulting in the effective cost of the loan being substantially higher than the headline interest rate.
  • What security will the mezzanine lender require? Because the mezzanine lender is at greater risk than the bank, the lender may require extensive security. It is important to ensure that the security that the lender requires can be given before any letter of offer is executed, as often the signing of a letter of offer will trigger an obligation to pay arrangement fees and other costs even if the loan is not advanced.
  • What protection is there from the lender? Mezzanine lenders are not subject to specific regulation and are generally entitled to take whatever action is permitted or provided for in the loan documentation. This may entitle the lender to take enforcement action with little or no notice or under circumstances where a bank or other regulated institution would not.

Lender’s considerations

  • What is the borrower’s exit strategy? Where will the borrower get the funds to repay the loan? Often this will be obvious, such as where the finance is being provided to fund say the development of an apartment complex. However, if the total debt is not covered by presales, there is a risk that, in the event that the development is completed but sales do not materialise, the borrower may not have the cash to repay the loan within the required time period.
  • What is the borrower’s skin in the game? Where a development is almost 100% debt funded, it may be an indication that the borrower has little if any assets available to fund any unforeseen events. This means that the development may be derailed by minor cost overruns preventing completion of the development and adversely affecting the borrower’s ability to repay.
  • Does the borrower or another entity hold all of the project’s assets? The answer to this question is often not straightforward. Through the use of development agreements and joint venture arrangements it can be the case that the developer or borrower is not the owner of the land being developed or the holder of all intellectual property relating to the development. This can cause difficulty if the lender needs to take control of a development to secure repayment of the loan.

Conclusion

Mezzanine finance is becoming more and more commonplace and, whilst there are risks for both the borrower and the lender, the risks can be managed with appropriate advice and by taking reasonable precautions. To protect itself, the lender must undertake legal due diligence regarding the borrower, the assets and the purpose of the loan. A property lawyer who is skilled in finance and experienced in the property market can provide that advice.

For more information contact:

John Morrissey — Senior Associate — Property, Commercial and Finance
(02) 6279 4439
john.morrissey@mvlawyers.com.au

Christine Murray — Partner — Property, Commercial and Finance
(02) 6279 4402
christine.murray@mvlawyers.com.au