Few smaller firms are cash rich, and in the property and construction sector that is especially true for smaller and medium developers.
With a speculate-to-accumulate business model, they must lay out large sums of cash up front and throughout the construction life of each development, if not beyond.
What’s more, those funds are typically tied up for many months and often years. And the situation has worsened since Brexit, Covid and the war in Ukraine with everything from planning through securing bank funds to getting materials on site taking longer than used to be the case.
Part of the problem for SME developers is that banks don’t like to lend against a development ahead of it securing planning permission, as there are no assets in the project yet against which to secure their loan.
But the developer must come up with funding to get the project up and running.
Even a small development of, say, two houses can incur upfront costs of £30-50,000 in planning and professional fees. For more complex projects, that number can easily top £100,000 when you factor in consultancy fees for a broader raft of planning hurdles such as right to light and environmental studies. Another big-ticket pre-planning bill can be option fees for the landowner.
"We have seen a big increase in demand for mezzanine funding as developers grapple with the cashflow challenges being heaped upon them.”
And the cashflow strain doesn’t necessarily go away once a developer navigates successfully through the planning process and secures a bank loan.
With many suppliers now demanding upfront payments, small developers increasingly find themselves dipping into their pockets to confirm deliveries.
That’s despite the cost of those materials being part of the business
plan that is supposed to be covered by the bank loan. Once again, it happens because banks typically dislike releasing funds that aren’t secured against tangible assets, in this case materials that are yet to arrive on site.
All this means that SME developers are often locked into their current project, unable to move onto their next because of lack of cash until the development completes and sells.
But what if there was a way to release cash for that next venture?
This is where second tier, or mezzanine, finance comes in. Evidence suggests it’s easing the pain for SME developers.
Chris Hector of mezzanine lender Davon, which specialises in residential projects, says: “We have seen a big increase in demand in the last year or so as developers grapple with the cashflow challenges being heaped upon them.”
Free up equity
By providing a tranche of second-tier finance behind the bank loan, specialist lenders such as Davon free up part of the developer’s equity that was previously locked into the current project. This can then be used to cover the upfront costs on the next development or to offset rising materials prices on the current one.
Chris Hector adds: “In its way, mezzanine finance might be described as a disruptive technology, changing the traditional way of funding developments and making strategies possible for smaller businesses that were once the preserve of deep-pocketed behemoths.”