Mezzanine financing, or mezz debt, can play a critical role in the funding of a community economic development project and has other advantages discussed in this post, but what exactly is it, and how does it work?
Financing the renovation of historic buildings is far more complicated than new construction on vacant land. Reuse of an older building adds both risk and limitations to the project. For example, the removal of hazardous chemicals adds risk, or low ceiling heights limit potential future uses.
Because of this increased risk, traditional lenders are even more conservative when analyzing these projects and will often only lend up to 50% of the total redevelopment costs. If the developer defers the majority of their fee and does a great job applying for and receiving tax credits and grants, they can get up to 30% equity to finance the project. But, after all this work, there is still a 20% hole, or gap, in the financing; this is where mezzanine debt comes into play.
Mezz debt fills the gap between what a typical lender will loan to a project (the senior debt) and all equity sources for the project. Project equity can come from a variety of sources, like the developer him/herself, grants, or tax credits, but the thing all of these funds have in common is that they are all ‘patient money,’ meaning, they have much more generous or flexible payback terms than debt from a traditional lender.
Because mezz debt plugs this hole in the financing between a bank loan and equity, it is often referred to as gap financing. Or, if you prefer, you can think of the sources of financing as layers of a cake, with traditional bank debt on the bottom, mezz debt in the middle, and equity on top. It is not uncommon for an historic redevelopment project to have seven, eight or more sources of financing, so the cake can get pretty tall.
So, where do I find mezz debt for community economic development projects, and how much does it cost? There are three major categories of mezz debt providers, and the cost varies between types of providers based on their motivation to make a loan.
First, some traditional banks or lenders and investment firms may provide mezz debt. Because these institutions are interested primarily in the financial return, the increased risk of this type of debt means you’ll pay back the loan at a much higher interest rate, often in the 12-15% range.
Second, some local governments may provide this gap financing because they are interested in the community and economic development benefits the project will bring. Local governments may provide financing at a fair market rate, or may be able to provide financing at a lower than market rate interest as a form of development incentive in the 8 – 10% range.
Finally, some investment firms, such as Natural Capital Investment Fund, specialize in financing projects with social and environmental benefits. Because, similarly to local governments, they are motivated by more than only the financial bottom, these loans may also have lower than market rate interest.
A critical aspect of mezz debt is that all of these providers allow their loan to be subordinate to the traditional lenders loan, the senior debt. This means that in the case of default, the traditional lender gets every penny of their money paid back before the mezz debt lender receives anything. Obviously, this puts the mezz debt lender in a riskier position than the traditional lender, hence the higher interest rate, but they are still guaranteed payback before any equity is returned.
Local governments accustomed to offering grants to encourage redevelopment of key properties may want to consider a role as a mezz debt lender for redevelopment projects. There is additional underwriting and servicing of the loan to manage, but the need for mezz debt is so great with traditional lenders having tightened their underwriting standards, a mezz debt loan from the local government may be the piece that makes the project viable. Municipalities with significant building stock available to redevelop may want to consider setting up a mezz debt fund to encourage redevelopment.
The Development Finance Initiative at the School of Government has helped communities across the state evaluate options for local government involvement in financing redevelopment projects.