Understanding the Capital Stack

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Development finance can be one of the most frustrating aspects of life as a property developer. With an array of potential lenders available to you, from high street banks to bridging lenders, each with unique requirements, risk appetites, geographical locations and leverage limits, it can be difficult to know whether you are being offered the best deal on the market. A 5% p/a interest rate from a high street bank may sound like a good deal compared to 8% from a challenger, but how does the lower gearing affect your profit margin? How does the expense of mezzanine debt compare to a profit share with an equity investor? How much equity do you need to inject into the scheme and how does this affect the number of projects you can do?

The Capital Stack

The capital stack is a description of the total capital invested in a project. At the bottom of the stack you have your senior debt (making up the largest section of capital), followed by mezzanine debt and at the top of the stack comes equity, which can be solely your own equity or can include equity from an investor. Each level comes with different risks for the lender and therefore different costs to you. Understanding the options open to you regarding how best to structure the capital stack is key to maximising your profits as a property developer.

Senior Debt

Senior debt is always at the bottom of the stack and can contribute between 40%-70% of the total costs of the project. It is called “senior” as it has the highest priority against the security provided (in the case of development finance, this is usually a first charge against the property). Senior debt can be secured from high street banks, challenger banks, alternative lenders and peer to peer lenders. Senior debt is the cheapest part of the capital stack because it comes with the lowest risk (in the event that something goes wrong, the bank can claim the property and sell it to recover their debt). Senior debt is usually paid for by a combination of arrangement and exit fees (0.5%-2% of the loan) and interest which can be between 5% and 9% depending on leverage (the higher loan as a percentage of GDV, the higher the risk to the lender and therefore the higher the interest rate).

Mezzanine Debt

Next up we have mezzanine debt. Mezzanine debt is usually secured from specialist mezzanine providers and can take your capital stack up to the lower of (usually) either 75% loan to GDV or 90% loan to costs. As is the case with all levels of the capital stack, different providers will have different requirements, costs and maximum leverage limits, so it is important to give yourself the broadest understanding of the options available to you on the market before making your decision.

Mezzanine debt can cost between 15% and 25% pa in interest along with entrance and exit fees, making it quite expensive compared to senior debt. This is due to the much greater risk involved for the lender. Mezzanine debt is most often secured with a second charge against the property (behind the lender providing the senior debt), meaning that, should the worst happen, in order to recover their money they have to wait for the senior lender to be fully repaid using their first charge against the property.

Just to confuse things slightly here, you also have the option of stretch senior debt available to you from some lenders. This is essentially securing senior and mezzanine debt from the same lender and is paid for with a “blended” interest rate (this could be 7% for the debt up to 60% loan to GDV and 20% for the debt from 60% – 70% LTGDV).

Equity

At the top of your capital stack is where you will find the equity component. Equity means risk capital and can either be your cash or a combination of cash from you and an investor. What is worth highlighting here is that both your senior lender and mezzanine lender (should you need one) will likely have a minimum equity commitment they require from the developers they lend to (between 5% and 25% of the total costs of the project).

As you begin to perform your market research and open up initial discussions with lenders, you will hear the term “skin-in-the-game” used quite regularly in relation to this equity requirement. Basically, the lenders want to know that you also have money on the line should the project go sideways so that you are not tempted to just try and walk away should the going get tough.

Equity, should you need to go elsewhere to source it, will be the most expensive aspect of your capital stack. Often it is paid for by some combination of interest rate, arrangement/exit fees and/or a profit share which can be 50% of your profits (after repayment of the senior / mezzanine finance costs).

How to Structure Your Capital Stack

The combination of senior debt, mezzanine debt and equity you use to fund your next development is a formula worth taking the time to consider. Let’s take an example to see how different combinations can affect your profit as a developer. In this scenario, our developer has £400,000 to put to work.

Project 1:

Project GDV – £2,000,000

Pre finance Costs- £1,500,000

Developer Equity available – £400,000

 

Option 1 – Senior Debt Only

Loan to GDV 60% = £1,200,000

Total Costs (including cost of debt) – £1,600,000

Developer Equity input = £400,000

Development Profit = £400,000

 

Option 2 – Senior and Mezzanine (finance costs increase to £150k with introduction of mezzanine)

Senior – Loan to GDV 60% = £1,200,000

Mezzanine = £200,000

Total Costs (including costs of debt) = £1,650,000

Developer Equity input = £250,000

Development Profit = £350,000

Here we see a clear difference. The finance combination in option 2 is more expensive and leaves the developer with less profit after completion of the project. So option 1 is the best option right?

Not so fast.

Option 2 leaves the developer with £150,000 equity sitting around burning a hole in their pocket while the development is being completed. A smart developer wouldn’t let this opportunity go to waste and would be on the look out for another project to commit this equity to.

Project 2

GDV – £1,000,000

Total Costs Pre finance – £700,000

Total Costs Including Finance – £750,000

Senior Loan to GDV – 60% – £600,000

Developer Equity – £150,000

Development Profit – £250,000

Development profit after both projects: £350,000 + £250,000 = £600,000

The lesson here is obvious. Understanding the capital stack, and how best to make your equity work for you is key to maximising your profit as a developer. Exactly how you decide to approach financing your development projects will be dependent on the money you have at your disposal, your appetite for growth, your experience as a developer and your knowledge of the options available to you.