When a developer applies for a construction loan, the bank will normally require that he contribute 20% of the total cost to build the project. In other words, if the total cost to build a condo project is $30 million, the developer will be expected to cover the first $6 million of the cost. The bank will provide a construction loan in the amount of $24 million to cover the balance of the cost.
But very few developers have an extra $6 million laying around to put into a project. The developer will then seek either a mezzanine loan, a preferred equity investment, or venture equity, typically from a pension fund or a mezzanine lender.
Let's say the developer has $3 million of his own money into the $30 million deal, which is 10% of the cost of the project. Three million is a sizeable investment. The developer may not be willing to give up part-ownership (equity) or even a percentage of the profits (equity kicker) in order to attract another $3 million in capital.
In a case like this, the additional $3 million investment by an outside investor may be structured as a mezzanine loan. Because the loan-to-cost ratio of 90% is high, the investment is very risky. Such a high mezz loan might be priced at 12% and 2 points, with an exit fee of 1 to 2 points.
Sometimes the underlying construction lender will be uncomfortable with a mezzanine loan behind them. Mezzanine loans have payments. If the developer defaults on these payments, some strange mezzanine lender from out-of-state and with no roots in the community will take over the project. The construction lender may therefore object to the mezzanine financing and refuse to sign an inter-creditor agreement.
In cases like this, the $3 million investment from the pension fund or mezzanine lender may be structured as preferred equity. A preferred equity investment is technically not a loan. If a preferred equity investor is not paid his agreed return, however, the preferred equity investor can still take over the project. The effect is little different than a mezzanine loan.
Let's assume in our example that the developer has a great project, but he lacks the cash to put up more than $600,000 or so. In a case like this, the developer will need to seek venture equity. A venture equity investor, often a pension plan, will sometimes contribute up to 90% of the developer's required equity!
In our example, the total project cost was $30 million. The developer's required equity is 20% of $30 million or $6 million. The venture equity investor may be willing to contribute up to 90% of that $6 million - or $5.4 million.
Venture equity is very, very expensive. A venture equity investor may demand a preferred return of 8%. In other words, before the developer makes a dime for all of his vision and hard work, the venture equity first gets a minimum of 8% on its investment. Then the venture equity investor may get 50% of all of the remaining profit.
A developer can find hundreds of commercial construction lenders and mezzanine lenders on C-Loans.com.
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