Mezzanine and Preferred Equity in Australian Development Funding

Most development projects are funded from more than one source. A senior lender provides the largest share of the cost, and the developer contributes equity. When the gap between the two is wider than the developer can fill, another layer of capital can sit in between. In Australia that layer is usually described as mezzanine finance or preferred equity.

This guide, prepared by Amar Alamar of Blended Ventures, explains how these two forms of capital work in a development funding structure, how they differ, how they are documented and when a developer might consider them.

The capital stack in a development project

Lenders and investors often describe a project's funding as a capital stack. At the base is senior debt, secured by a first mortgage over the site and usually the lowest cost money in the structure. At the top is the developer's own equity, which is repaid last and carries the most risk. Between them, a project may include one or more layers of subordinated capital.

Each layer is repaid in order. Sale proceeds or refinance funds go first to the senior lender, then to any mezzanine lender, then to any preferred equity investor, and only after that to the developer. The higher a party sits in the stack, the more risk it accepts and the higher the return it expects.

How much senior debt a project can support depends on how the lender applies its cost and value tests, which is covered in Loan to Cost and Loan to Value. Where senior debt and the developer's available equity do not cover the full project cost, subordinated capital is one way to fund the shortfall.

What mezzanine finance is

Mezzanine finance is a loan that ranks behind the senior facility. In Australian property it is most often secured by a second registered mortgage over the site, supported by guarantees from the sponsors and sometimes by security over the shares or units in the development entity.

Because the mezzanine lender is repaid only after the senior lender, its position depends heavily on the agreement between the two. A deed of priority, or an intercreditor deed on larger transactions, sets out how much the senior lender can recover ahead of the mezzanine lender, whether the mezzanine lender can step in or buy out the senior loan if it falls into default, and what notice each party must give before enforcing. The guide Commercial Second Mortgages in Australia explains how priority between first and second mortgagees generally works.

Interest on a mezzanine facility is commonly capitalised and repaid at completion, together with establishment and exit fees. Pricing is well above senior debt, reflecting the later ranking and the thinner margin of value that protects the loan.

What preferred equity is

Preferred equity is an investment in the project entity itself. The investor takes units, shares or a contractual interest that entitles it to a preferred return and to the repayment of its capital before the developer receives any profit.

As equity, it generally ranks behind all secured debt, including any mezzanine facility. Its protections come from the shareholder or unitholder agreement, which may give the investor approval rights over major decisions, rights to step in if the project falls behind program and a priority claim on distributions. Some senior lenders are more comfortable with preferred equity than with a second mortgage, because it does not add another registered security over the site.

The return may be a fixed preferred rate, a share of profit above that rate, or a combination of the two. The documentation is usually more involved than for a loan and can take longer to negotiate, so it needs to be started well ahead of the date the funds are required.

How the two compare

Mezzanine finance and preferred equity fill the same part of the stack. The choice between them often comes down to what the senior lender will accept and what the developer is prepared to give up in control and profit share.

Security: mezzanine finance is normally secured by a mortgage, while preferred equity relies on rights within the project entity.

Ranking: mezzanine debt ranks ahead of preferred equity, which ranks ahead of the developer's ordinary equity.

Control: preferred equity investors often ask for a greater say in decisions, since they have less security to fall back on.

Return: mezzanine lenders are paid interest and fees, while preferred equity investors may also share in the upside.

Senior lender consent: both usually require it, and many senior lenders have firm policies on which structures they will allow.

When subordinated capital makes sense

Subordinated capital is expensive, and it adds parties, documents and time to a transaction. It tends to make sense when it allows a viable project to proceed that could not otherwise be funded, or when it frees the developer's own capital for another opportunity that justifies the cost.

Typical situations include a developer who holds an approved site but does not have the full equity contribution a senior lender requires, a project where presales have not yet reached the lender's hurdle, or a sponsor who would prefer to spread equity across more than one project. Subordinated capital can also play a part in the step from a land facility into a construction loan, which is discussed in Construction Finance in Queensland.

The feasibility has to carry the cost. Cost overruns and delays reduce the developer's profit first, and adding expensive capital to a project with a narrow margin leaves less room to absorb them. Mezzanine lenders and preferred equity investors test the feasibility closely for this reason, and they usually expect the developer to retain a meaningful equity contribution of their own.

Preferred equity in today's market

Appetite for subordinated capital moves with market conditions. In the current market preferred equity is very limited, and the providers that remain active are selective about sponsors, locations and exit strategies. Mezzanine finance is still offered by a number of private credit funds, though terms differ widely from one provider and one project to the next.

For developers, a funding plan that depends on preferred equity should allow time to find it and should include an alternative in case it cannot be secured on acceptable terms. Early discussion with the senior lender about what subordinated capital it will accept can save considerable time later.

What to prepare before approaching funders

A developer considering mezzanine finance or preferred equity can usually get a faster and clearer response by preparing:

The development approval and its conditions.

A current feasibility showing the full capital stack and the proposed return to each layer.

The senior facility terms, or an indicative term sheet, including the senior lender's position on subordinated capital.

Evidence of the developer's equity contribution and its source.

Presales or leasing evidence, where relevant.

The builder, the construction contract and the quantity surveyor's cost report.

A summary of the sponsor's track record and the project team.

The proposed exit and its expected timing.

The role of Blended Ventures

Blended Ventures is a finance brokering consultancy founded by Amar Alamar, working with developers, property owners and investors from the Gold Coast and Brisbane. It connects clients with private credit funds, non-bank lenders, banks and capital partners, and can arrange mezzanine finance and preferred equity alongside senior debt, although preferred equity is very limited in today's market.

Each engagement starts with the full capital stack, so that the senior, subordinated and equity layers are considered together and the senior lender's position on subordinated capital is understood early. More information is available at blendedventures.com.au.

Important information

This article is general information only. It is not financial, credit, legal or tax advice and does not take into account any person's objectives, financial situation or needs. Blended Ventures is a finance broker, not a lender. Any finance is subject to the relevant lender's assessment, credit criteria, security valuation and approval. Readers should obtain independent professional advice before acting.