ANZPJ Mar16 Mezzanine

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ALTERNATIVE FINANCE ALTERNATIVE FINANCE

THE
RISE
OF
the capital requirements on banks, to the ABS. This reflected an up to 50%5. The development sector
with the average risk weight on increase of 14.7% year-on-year. was one of the hardest hit during the
Australian residential mortgage The rapid growth in housing downturn. Defaulting mezzanine

MEZZANINE
exposures increasing from finance has corresponded with a loans were a major contributing factor
approximately 16% to 25%. stronger demand for mezzanine to Octaviar subsequently being placed
APRA’s regulatory requirements
have had an immediate impact on

DEBT
the Australian housing market, with
auction clearance rates slipping to
REAL ESTATE PLAYERS MUST UNDERSTAND
62.1% for the December quarter of
THAT THE INTRODUCTION OF MEZZANINE DEBT
2015 according to CoreLogic RP Data.
WILL RESULT IN A LESS ROBUST FINANCIAL
Buyers are slowly regaining leverage
STRUCTURE AND A HEIGHTENED SENSITIVITY
as the pendulum begins to swing
TO MACRO-ECONOMIC HEADWINDS.
back, but still in an environment
where finance is more difficult debt. We expect this demand into liquidation. As one disappointed
Following tighter regulatory requirements from senior lenders, property investors to secure and competition for the to accelerate in the near term retail investor explained, “I am bitterly
limited source of available capital for several reasons, including disillusioned … that our hard-earned
and developers can consider mezzanine debt to secure finance. Trident real becomes fierce. Unsurprisingly, increasingly strict lending policies savings were going into mezzanine
estate’s COSTA ARGYROU and SHIRLEY SONG explain the risks and benefits. the need for alternative funding by the big four banks, the surge loans for shonky, over-geared
sources is increasing. in construction and property Australian developers who, when

M
development, the low interest rate things got tough, disappeared into
ezzanine debt While mezzanine finance has the STRICTER LENDING PAVES THE environment, and the unattractive a mix of smoke and mirrors.”6
is set to become benefit of increasing a borrower’s WAY FOR ALTERNATIVE FUNDING MEZZANINE FINANCE alternatives to mezzanine debt such
an important expected return for equity, and The Sydney property market is IN REAL ESTATE as introducing an equity joint venture
source of capital reducing equity needs, this comes currently a hotly debated topic. In real estate, mezzanine finance is partner, resulting in the ceding of TYPICAL DEAL TERMS
for real estate at a cost in the form of higher debt Price growth of 17% and 14% over used in three distinct categories —  control and profits to third parties. As a rule of thumb, a mezzanine
investors and developers looking repayments (impacting cash on cash the last two years respectively has property development, investment Real Estate players must provider will provide 10% more
to refinance following the tougher returns), increasing the probability of lifted the median house price to properties and value-add properties. understand that the introduction gearing than the senior debt provider.
capital regulatory requirements default. Understanding the real risk of an estimated $960,000 at June The Australian residential real of mezzanine debt will result in For example, in a development project,
and tighter underwriting mezzanine debt is critical in order to 20153. In the short term, this price estate market is now worth $5.7 a less robust financial structure the mezzanine financier may lend up
by the big four banks. weigh-up whether the expected return is growth is expected to continue, trillion dollars. In August 2015, and a heightened sensitivity to to 75% loan-to-value (net) and 90%
Mezzanine finance bridges commensurate with the additional risk albeit more moderately, given the the value of outstanding housing macro-economic headwinds. loan-to-cost, and will often take a
the gap between senior debt and transaction complications involved. low interest rate environment set loans financed by banks reached The demise of Octaviar presents view on land value uplift. All other
and equity investment, with the Recent research conducted by the Centre by the Reserve Bank of Australia $1.37 trillion dollars, enjoying an a cautionary tale of the heightened
mezzanine lender sitting above of Private Equity Research (CEPRES)1 (RBA), the state’s dwelling deficiency increase of 8.4% for the year4. risks associated with mezzanine
equity in the capital structure shows that, on average, mezzanine and strong investor demand. In the 12 months leading lending. Octaviar, formerly known 5A
 ccording to Ferrier Hodgson, in their
but subordinated to the senior loans have a default rate2 of 16.1%. To curb excessive risk taking up to August 2015, the total as MFS Limited, was a Queensland paper titled “Queensland Property
Buffeted by An Ill Wind”, the GFC may
debt. Mezzanine finance appeals in the property market, the value of building approvals for based property finance group. As a have initiated Queensland’s property
to a certain class of borrowers Australian Prudential Regulation residential construction equated specialist mezzanine lender, Octaviar market downturn, but the sector suffered
as it is cheaper than their own 1 See Centre of Private Equity Research. Authority (APRA) has increased to $65.39 billion, according raised funds from retail investors, multiple blows ranging from lower
Private Debt Market Report Q2/2015. Rep. levels of net migration to the downturn
cost of equity and avoids the promising high yields of up to 8% in tourism, the devastating Queensland
Munich: CEPRES GmbH, 2015. Web.
loss of control and potential per annum. The impact of the Global floods and Cyclone Yasi, along with an
2C
 EPRES defines the term default rate to ongoing lack of finance.
complications introduced by an 4 Australian Bureau of Statistics (ABS) Financial Crisis (GFC) resulted in the
mean the number of transactions with 3 BIS Shrapnel. “Residential Property
equity joint venture partner. cash on cash multiple <1 divided by the Prospects 2015-2018”. N.p., June 2015, “Housing Finance Australia, collapse of the Queensland property 6 “Investors Back Octaviar Offer of
number of all transactions. 2015. Web. Aug 2015”, Australian Bureau of market, with asset values falling by Cash Payout”. Stuff. N.p., n.d. Web.
Statistics, Canberra. 07 Jan. 2016.

292 ANZPJ MARCH 2016 293


ALTERNATIVE FINANCE ALTERNATIVE FINANCE

TABLE 2 CASH FLOW MODEL (WITH MEZZANINE DEBT)


conditions typically mirror the senior $48,000,000. Selling costs (of 2%)
lender’s requirements.
IN A VANILLA plus additional capital improvements
According to Nick Beckett, a
MEZZANINE DEAL will bring the total purchase price
Closing Year 1 Year 2 Year 3 Year 4

director and head of mezzanine


FOR AN INVESTMENT up to $50,000,000. The net operating
NET OPERATING INCOME
Sale Proceeds
($50,000,000) $4,000,000 $4,160,000 $4,326,400 $4,499,456
$56,243,200
finance at Balmain Corporation, “in
ASSET, THE income (NOI) in year one is forecast Total Cash Flow Before Debt
such deals, mezzanine lenders would
MEZZANINE DEBT to be $4,000,000, and this is set to
Service ($50,000,000) $4,000,000 $4,160,000 $4,326,400 $60,742,656

receive a fixed income yield, in the


WOULD INCREASE increase by a fixed 4% per annum
Unleveraged Yield 8.00% 8.32% 8.65% 9.00%

14% to 18% range as well as upfront


THE LEVERAGE FROM for the following four years.
Unleveraged IRR 11.10%

fees of 1.5% to 3%”. Pricing will


THE STANDARD 65% Using CoreLogic RP Data
SENIOR DEBT 4.85%

depend on the type of project and its


TO 75% OF COST and comparable transactions, a
Senior Debt Service Payments $32,500,000 ($1,576,250) ($1,576,250) ($1,576,250) ($1,576,250)

risk, however, plus the experience of


TO AS HIGH AS 75% going-out capitalisation rate of 8%
Cash Flow Available for
Mezzanine Debt $2,423,750 $2,583,750 $2,750,150 $2,923,206

the borrower, leverage levels, loan size


TO 85%. is used, representing a sales price
MEZZANINE DEBT 15.00%
Mezzanine Debt Service $10,000,000 ($1,500,000) ($1,500,000) ($1,500,000) ($1,500,000)
and geographic location of the asset. in year four of $56,243,200.
Cash Flow Available for Equity ($7,500,000) $923,750 $1,083,750 $1,250,150 $1,423,206
In a vanilla mezzanine deal for for commercial property, leads to An interest-only bank bill
an investment asset, the mezzanine lower first mortgage leverage. business loan of 65% of leverage Net Cash Flow From Sales $13,743,200
Proceeds
debt would increase the leverage is available. Interest on the debt is
from the standard 65% to 75% of AN ANALYST’S TASK – A 2.75% above the Bank Bill Swap
Before Tax Cash Flow
Cash-on-Cash Return
($7,500,000) $923,750
12.32%
$1,083,750
14.45%
$1,250,150
16.67%
$15,166,406
18.98%
cost to as high as 75% to 85%. For HYPOTHETICAL CASE STUDY Bid Rate (BBSY) of 2.1%. SREF Leveraged IRR 28.63%
bearing risk in excess of the first Sydney Real Estate Fund (SREF) is is now considering a mezzanine
mortgage, the interest rate on the a closed end real estate investment loan of $10,000,000 to increase
mezzanine debt generally ranges fund focused on urban investments. the leverage on the asset to 85%;
from 12% to 15%, with upfront fees The Fund’s investment strategy this interest-only loan carries a TABLE 3 CASH FLOW MODEL (WITHOUT MEZZANINE DEBT)
being in the range of 1.5% to 3%. is to identify and capitalise on 15% interest rate and a five year
Such a capital structure usually the development, acquisition, term-to-maturity. In the alternative, Closing Year 1 Year 2 Year 3 Year 4
results in very low  to less than one repositioning, and adaptive reuse SREF can raise equity equivalent NET OPERATING INCOME ($50,000,000) $4,000,000 $4,160,000 $4,326,400 $4,499,456
times interest cover ratio on the of urban real estate. to 35% of the total cost, or Sale Proceeds $56,243,200
subordinated debt. Until APRA’s SREF has been approached with $17,500,000. See Table 1 for the two Total Cash Flow Before Debt ($50,000,000) $4,000,000 $4,160,000 $4,326,400 $60,742,656
Service
recent intervention, many investors an investment memorandum titled alternative capital structures.
Unleveraged Yield 8.00% 8.32% 8.65% 9.00%
had high gearing senior debt options ‘The Rosebery’. The Rosebery is a Tables 2 and 3 depict the Unleveraged IRR 11.10%
available. As a result, mezzanine multi-story class B office building cash flows and performance SENIOR DEBT 4.85%
debt in the investment real estate with 10,000 square metres of net measurements when modelling Senior Debt Service Payments $32,500,000 ($1,576,250) ($1,576,250) ($1,576,250) ($1,576,250)
space was uncommon. This is now lettable area, which is fully leased. our hypothetical case study with Cash Flow Available for Equity $2,423,750 $2,583,750 $2,750,150 $2,923,206
changing as stringent underwriting The purchase price for the building and without mezzanine debt. Our Net Cash Flow From Sales $23,743,200
Proceeds
by the big four banks, particularly located in inner city, Sydney is analysis shows it is accretive to the
Before Tax Cash Flow ($17,500,000) $2,423,750 $2,583,750 $2,750,150 $26,666,406
Cash-on-Cash Return 13.85% 14.76% 15.72% 16.70%
Leveraged IRR 21.53%

TABLE 1 FUNDING STRUCTURES


Capital Structure (With Mezzanine) Capital Structure (Without Mezzanine)
Uses Uses
overall equity returns, because the 14.45%) because of the subordination EXIT STRATEGY OF
Purchase Price $48,000,000 Purchase Price $48,000,000
cost of the additional debt (15%) of returns from the equity. The MEZZANINE LENDER
Clothing Costs & 2.0% $960,000 Clothing Costs & 2.0% $960,000
Expenses Expenses is less than the leverage return to mezzanine borrower is prioritised, Mezzanine financing generally has
Capital Improvements $1,040,000 Acq. Costs Capital Improvements $1,040,000 Acq. Costs
equity (21.53%). Additionally, the and grabs much of the cash flow in a short- to medium-term maturity
$1,040,000 $1,040,000 overall returns to equity move the early years of the investment. of two to five years, while property
Total Uses $50,000,000 Total Uses $50,000,000 from an internal rate of return of Where the borrower is not successful investors typically have a longer-term
21.53% without mezzanine debt in raising the net operating income investment horizon. Conflict may
Sources LTV Sources LTV to 28.63% with mezzanine debt. of the asset, the returns or cash flow therefore arise when the mezzanine
Senior Debt $32,500,000 65.00% Senior Debt $32,500,000 65.00%
The cash-on-cash returns to to the equity holder could remain loan expires. Forward planning and
SREF in years one and two are low and may even result in default agreeing to a mutually convenient
Mezzanine Debt $10,000,000 20.00% Total Equity $17,500,000 35.00%
lower as a result of the introduction in situations where vacancy in the exit strategy should be a priority.
Total Equity $7,500,000 15.00%
of mezzanine debt (13.85% and investment asset increases as a result Paying down the mezzanine debt
Total Uses $50,000,000 100.00% Total Uses $50,000,000 100.00%
14.76% as opposed to 12.32% and of a dip in the economic cycle. can occur in multiple ways. When

294 ANZPJ MARCH 2016 295


ALTERNATIVE FINANCE

a borrower sells the asset, assuming between the mezzanine lender in order to discharge the debt,
the subordinated debt is not under and the senior financier. interest and other fees owing to
water, the proceeds are used to repay Many senior creditors will the senior lender. Any residual
the principal interest and fees owed typically refuse to negotiate deeds funds remaining are then used
to the senior and mezzanine lender. of priority, particularly if the loan to repay the mezzanine lender in
Alternatively, where a property has already closed. However, senior priority to the shareholders.
has made significant capital gains, creditors do often accept that The senior lender may also
appoint an administrator, with
a view of entering into a deed of
company arrangement (a DOCA).
SENIOR CREDITORS DO OFTEN ACCEPT THAT A DOCA binds all stakeholders,
MEZZANINE LENDERS CAN BRING VALUE including secured and unsecured
TO THE TABLE, PARTICULARLY WHERE THE creditors, and governs how the
MEZZANINE LENDER IS AN EXPERIENCED REAL borrower’s affairs may be dealt
ESTATE PLAYER. with. According to Ryan Spooner,
a director at Ferrier Hodgson, “the
refinancing allows a new first mezzanine lenders can bring value to terms of the DOCA are flexible,
mortgage to take out the original the table, particularly where with the majority of creditors
senior and mezzanine provider. the mezzanine lender is an motivated to accept a DOCA
In a development project scenario, experienced real estate player. proposal on the basis that the return
the mezzanine debt will be Active mezzanine managers may is greater than a liquidation, or the
introduced to fund part of the reduce default rates with better agreement increases the prospects
development costs, along with the access to information and earlier for a turnaround to occur”.
construction loan. The mezzanine intervention strategies, as well as
debt will have the interest capitalised terms structured to protect on the
during the duration of the project. downside, and by ensuring a seat at CONCLUSION
On the pre-sales settlement date, the table in the event of default 8 . Sophisticated quality underwriting
the proceeds from the off-the-plan Unlike the senior lender, a by mezzanine lenders is critical
sales are used to pay down the mezzanine lender will not be for real estate investing in the
construction loan, along with the permitted to enforce their security. current lending environment, with
mezzanine debt (a balloon payment). Often the only commercial a strong focus on exit strategies
Alternatively, refinancing and alternative is to cure the default and timing, in addition to the
granting of the permanent loan by refinancing the secured past record and experience of
post practical completion of the property, or taking out the senior the real estate borrower.
project means that new, cheaper lender at par value (subject to all Real estate players must analyse
finance can generally replace the the prepayment penalties)9. the downside scenarios when
more costly construction loan Should the mezzanine lender running their feasibility models.
and mezzanine funding 7. not wish to exercise its right to cure What are the consequences if
or take out the senior loan when property values decline as they
default is subsisting, the senior did during the late 1980s and early
MEZZANINE LENDER lender may appoint a receiver 1990s? How are property cash
RIGHTS AND REMEDIES to realise the secured property flows, capitalisation rates and exit
In the event of a default, a strategies impacted by the upward
mezzanine lender is restricted movement of interest rates?
by those limitations set out in Borrowers must decide if the
8 “ Mezzanine Debt Offers the Best of
the ‘Priority Deed’. The Priority Both Worlds…or Does It? ” Investment increased returns justify the additional
Deed is an important document Magazine. N.p., 4 Sept. 2009. Web. risks and costs that accompany the
governing the relationship 9A
 mezzanine lender will only exercise introduction of mezzanine debt. 
its right to cure defaults, or its right to
purchase the senior debt, when the This article has been reduced for
subordinated lender believes they can
7T
 his assumes that enough value will have take control of the secured property and publication. To access the full
been created for the construction lender increase its value, or where the secured original paper with more details,
and mezzanine provider to be taken out at property’s value is greater than the sum visit http://bit.ly/1mYLFDe.
the conclusion of the project. of all outstanding security.

296 ANZPJ MARCH 2016


EQUITY
In these instances, two or more persons may contribute
equity in a real estate investment. This may take the form
of a joint venture, joint tenancy, tenants in common,
partnership, trust, et al. Equity may be structured PREFERRED EQUITY
in a pari passu manner, or take on some of Under this arrangement,
the characteristics of subordinated debt, the investor makes its
SENIOR DEBT or a range of options in between. investment and receives a
This is typically preferred return (in the form
the majority of the of fixed annual payback as
stack. Senior debt is opposed to interest payments) and
generally secured by can potentially participate in
the property, which the upside or profits of the
serves as collateral project. In the event of
for the loan. The non-payment or breach,
risk of senior debt the preferred owner

FINANCING
is the lowest of all dilutes the equity, or
of the layers in the buys out the equity.
stack due to its This sort of finance
security interest is common
in the collateral. in the US.

MEZZANINE OPTIONS CROWD

FOR REAL ESTATE


FINANCING FUNDING
The term refers to Crowd funding
debt, subordinated involves the pooling

DEVELOPMENTS
to the senior debt. The of financial resources
mezzanine debt may be from many different
further split into different individuals to convert
ranking tranches in larger an idea into a project or
project. Each tranche of Information supplied by Trident Real Estate Capital.
business. This can rely on
mezzanine debt may be a few large donors, or many
ranked in accordance with small ones. Funding needs and
where it sits in the capital purposes are communicated
stack and each tranche may broadly, in a forum where this
have different characteristics, can be evaluated by the ‘crowd’,
which can be tailored BONDS (SECURED DEBTS) or audience, usually carried
to meet an investor’s Stricter lending requirements have resulted in out on the Internet.
preference. Rates of return large and reputable developers tapping into the capital
are tied to seniority. markets as a source of finance. Bonds are typically issued
at a fixed rate and maturity, and generally secured against
the overall asset backing of the company. Where there is an
existing bank loan, the securitisation of the bond instead relies on a
‘negative pledge’ that works to contain the issuing company’s debt level.

Information supplied by Trident Real Estate Capital.

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