How to invest in a construction project overseas: mezzanine loans and equity partnership

With increasing fervor, foreign buyers are flocking to invest in construction and redevelopment projects, also known as value-added projects, rather than simple rental businesses.

In fact, across Europe, the proportion of investors opting for value-added projects surged from 22% in 2012 to an astounding 47% in 2016, according to the European Association for Investors in Non-Listed Real Estate Vehicles.

This is largely attributable to yields; global yields are declining. In Europe, you can expect an average of 3-7% per annum from a simple rental business. Meanwhile, value-added projects will typically earn you 12-20%.

Despite this key advantage, value-added loans can be difficult to pull off due to funding issues. Banks are conservative lenders, and tend to be wary of taking too many risks. As such, it can be difficult get a bank loan of more than 50% of the total project cost.

As such, conventional value-added project developers typically cover at least 50% of each project cost out of pocket. However, if a developer lacks the financial freedom to put down this sort of money, his or her next best bet is to seek investors.

Investors can get involved in such projects in two ways:

1. Become a mezzanine investor: the investor lends capital to the developer in exchange for a fixed interest for the utilisation of the funds and gets a share in the profits obtained from the project.
2. Become an equity partner: the investor provides the developer with equity capital, participates in the project, benefits from operating profits and bears the consequences of the risks inherent to the project.

Each of these schemes has its own advantages and disadvantages.

Mezzanine financing

Mezzanine financing is a hybrid of debt and equity financing. Basically, it is a subordinated debt that has secondary priority after the senior debt – the bank loan. It is secured by a pledge of shares or by equity. The borrower is usually a Special Purpose Vehicle or SPV created by the developer.

The main advantage of mezzanine financing is that they tend to offer higher interest rates than bank loans. In the United States, for instance, interest rates typically range between 8-15% per annum. Despite the high rates, developers are willing to use mezzanine loans to get extra financing – typically with the aim of obtaining up to 70% of the project’s value, including the capital obtained from the bank. Doing so enables the developer to reduce the value of their equity in the project and to achieve higher yields, given that in such cases the developer typically only has to come up with 30% of their own funds to finance the project.

In addition to the increased interest rates associated with mezzanine loans, investors can benefit from extra yields, depending on the profitability of the project. This option is known as an "equity kicker" and is typically structured in the form of one of two types of securities: options or warrants.

The scheme of capital distribution with the attraction of mezzanine financing

Compared to simple rental businesses, value-added projects are relatively high-risk; there are significantly more cases wherein participants either fail to earn profits, or even incur losses. At worst, the investor stands to lose all of the capital he or she contributed in the first place. Experienced market players develop a knack for finding projects that will most likely enable them to break even, even if the market situation takes an unfortunate turn.

The specific risks associated with value-added projects are numerous: more time spent endeavoring to obtain a construction permit, an increase in the project budget, failure to achieve a sales target, etc. The savvy investor calculates each project’s susceptibility to negative outcomes and evaluates the maximum value by which the price per square meter can decrease or the project execution time can increase before yields will drop to zero. As a rule of thumb, a project that can sustain price decreases of 20% or a project time increase of 20% is probably stable enough for investment.

At the same time, the bank and mezzanine investor typically maintain a safe distance from the risk. In most cases, the first to earn nothing under a negative scenario is the developer. It is important to verify this in each case before investing.

Equity capital

The developer can choose one of two alternatives with respect to his or her own funds: pay out of pocket or attract an equity partner.

An equity partner is an investor who partially finances the project in exchange for a share in the profits. If an equity partner is involved in a project, his or her capital typically comprises about 20% of the project cost. In this scenario, the partner would shares the risks and profits of the project with the developer.

In this case, the developer provides the remaining 10% of the project´s cost, showing the equity partner that the project is worth investing in, as the developer also takes on the corresponding financial risks.

The scheme of capital distribution without mezzanine financing and an equity partner

The developer can also attract the capital of an equity partner without mezzanine financing. Under this scheme, the project is financed by three parties: a bank that provides the primary loan, an equity partner and an investor.

The scheme of capital distribution without mezzanine financing but with an equity partner

As for the distribution of the profits in value-added projects, the order is typically negotiated on a case-by-case basis. For instance, the equity partner may negotiate a priority yield, whereby he or she would be first in line to get a share of the profits to a certain extent, such as 6-8%. In this case, upon passing that threshold, the developer may receive the same yield on the capital he or she injected into the project. The remaining profit may then be distributed progressively between the two; i.e., the higher the project yields, the larger the share of the profit that goes to the developer. For example, it’s common for equity partners and developers to agree that the developer will get 30% of all profits within the yield range of 8-15% per annum, and that anything above 15% would be divided evenly between the pair.

In 2017, taking into account the current U.S. and European market situations and the above-mentioned scheme of profit distribution, investors could expect to get 12-20% per annum from value-added projects.

In sum, an investor who opts to become a mezzanine lender faces relatively low yields, but also takes on relatively few risks owing to the fact that in the event of bankruptcy, the developer is first to bear losses, followed by the equity partner, with the creditors trailing behind. On the contrary, an investor who opts to become an equity partner stands to earn relatively high profits, but also takes on greater risks.

This article only reflects the general principles of the relations between the participants of the developer projects. An investor's interest in a project can vary broadly depending on the market and the project considered. Moreover, the distribution of risks and yields also depends on the balance of the capital distributed between the developer, mezzanine investor and equity partner. As such, it is vital to seek a professional consultation before pursuing a new value-added project as an investor.

George Kachmazov, managing partner at Tranio

Originally published on globalrealestateexperts.com