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Examination of Alternative Finance Mechanisms

GCC real estate development finance markets are at an inflection point in their maturation lifecycle, expected to move swiftly from a characteristic emerging market dynamic to a developed market dynamic. This blog elaborates on the alternative finance mechanisms which are expected to gain in popularity in the GCC in the next 5 to 10 years.

Examination of Alternative Finance Mechanisms

The primary alternative finance mechanisms utilized in developed markets are mezzanine finance and private equity (PE) finance – both of which could see a significant rise in market share in the GCC over the coming decade.

  • Mezzanine Finance

Mezzanine finance is a flexible mechanism utilized by developers in more mature markets as ‘’bridge financing’’ to fill the gap between developer equity and the maximum amount that banks provide as senior debt. In international mature markets, bank finance for real estate development projects typically does not exceed a 75% LTV (loan to value) ratio, leaving 25% of the total project cost to be filled by other finance mechanisms. Mezzanine finance fills this gap by providing a hybrid debt/equity solution to developers, allowing them to fund projects without investing significant developer equity. Typical deal structures in international markets combine a debt mechanism with an interest rate and repayment schedule, and an equity mechanism which extracts a profit-share from the project net revenues.

Mezzanine investment mechanisms carry a higher risk profile than senior debt loans and are typically structured as investment funds. The global mezzanine market reached USD $23-Billion in 2020 as per Pensions & Investments’ annual survey. However, mezzanine finance is not a common development finance mechanism in GCC markets. While statistics for GCC markets are unavailable, anecdotal evidence shows a limited number of active mezzanine funds in GCC markets, with a usage rate of less than 10% of total development projects.

  • Private Equity

Private equity (PE) finance provides a structured equity investment into a real estate development project, again reducing the amount of developer equity required to fund a project. PE funds typically provide at-risk capital for development projects in a Joint-Venture (JV) structured deal and realize returns through a share in the end-profits of the completed project. PERE (private equity real estate) funds are high-risk investments and like mezzanine mechanisms, are typically funded and structured in an investment fund format. Developers utilize PE finance both as a risk management mechanism, as well as a source of funds to deliver larger projects where developer equity is insufficient.

As a risk management tool, PE funds share development risk with the developer by investing at-risk capital into the project, reducing the developer’s financial exposure. As a source of finance, PE funds allow developers to deliver larger projects in cases where the developer does not have sufficient equity to meet the bank’s LTV requirements for senior debt. Private equity finance for real estate development projects has grown rapidly in mature international markets in the past 20 years. Global private equity investment into real estate development projects reached USD $222-Billion in 2020, down 50% from pre-Covid-19 levels as per the 2021 Preqin Global Real Estate Report.

While family offices and informal investment groups invest in development projects in GCC markets, formally structured PE Funds are still uncommon as compared to international markets. Given the recent rise of real estate investment trusts (REITs) in GCC markets, the logical next step in the GCC’s market maturation process would seemingly be the introduction of large-scale, formally regulated PE Funds as a funding source for development projects.