Mezzanine-style lending gains in popularity but it has risks for investors

FinanceThe drive for 20 per cent-plus returns on commercial property investments has stimulated interest in mezzanine-style funding which has figured in a number of recent property deals.

This involves investors lending money to developers to make up a shortfall in their own equity funding. These type of transactions, usually offering better returns than those available on dry investments, raise a number of important questions for would-be investors.

Some advisers say that investors should ensure that their interests are aligned with those of the developer - as the developer is usually in the best position to evaluate the true underlying risks and returns.

Typically, mezzanine finance is more "senior" to the developer in terms of distributing gains. In that sense all parties are usually well aligned. However, a more recent innovation in the market appears to be somewhat different. Most of these arrangements pay a fixed return at maturity (typically seven to eight years) with an option for the developer to buy out the mezzanine over a shorter time frame. Arguably, developers are paying for the option to buy, in order to substantially increase their equity stake in a deal at a later stage - typically after the planning risk is reduced. In most of these transactions, the mezzanine holder is "capped" in terms of the return they can achieve, while downside remains equity-like.

Arguably, this disadvantages the mezzanine holder as they are taking the planning and development risk but, by being limited in terms of return, it is an open question as to whether they are getting sufficient reward for the scale of risk being taken.

Looking at development transactions in three stages - planning, construction and letting - underlines the different levels of risk that investors are taking.

Many developers acknowledge that the bulk of the risk in most development transactions rests in the planning stage - a good reason why investors should be seeking maximum gains for this element. Before committing to such a transaction, investors are frequently advised to be satisfied as to whether the returns being offered are commensurate with the risk. They also need to be happy with the potentially longer term, illiquid nature of the investment if the developer doesn't exercise his right to buy out the mezzanine financiers in the short term.

The only person who knows whether an investor is being sufficiently rewarded is the developer. If the developer's interests and that of the investor aren't fully aligned there could be trouble down the line.