Just starting out as a property developer? Beginning to explore development finance? Chances are you’ve come across the term ‘capital stack’.
Deciphering this piece of industry jargon is probably the last thing you want to do. No doubt you’re already occupied with the bewildering array of potential lenders on the market, from high street banks to bridging lenders, each with their own unique requirements, risk appetites, geographical locations and leverage limits.
This range of options raises multiple questions. For example: 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 your scheme and how does this affect the number of projects you can do?
However, understanding the capital stack will help you to answer these and similar questions. If you get to grips with the concept now, the development finance market will become easier to navigate.
The capital stack is a metaphor for the total capital invested in a development 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, equity. (Equity can be your own funds or investment from a third party.)
Each level of the stack 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.
Let’s take a closer look at each level in turn.
Capital Stack Level 1: Senior Debt
Senior debt is always at the bottom of the stack and can contribute 40%-70% of the total costs of a 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. It’s 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 lenders usually charge a combination of arrangement and exit fees (0.5%-2% of the loan) and interest which varies according to leverage. The higher the loan as a percentage of GDV, the higher the risk to the lender and, therefore, the higher the interest rate. A low leverage loan might come with an interest rate of 9% p.a., while higher leverage might come with rates of up to 13%.
Capital Stack Level 2: Mezzanine Debt
The second level of the stack is mezzanine debt (or ‘mezz’).
Mezz is usually secured from specialist providers and can take your capital up to either 75% loan-to-GDV or 90% loan-to-cost. As is the case with senior debt, 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 on the market before making your decision.
Mezzanine debt can cost between 15% and 25% p.a. 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. Mezz 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 the mezzanine lender has to wait for the senior lender to be fully repaid using their first charge against the property.
Capital Stack Level 3: Equity
The third and final level of the 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 senior lenders and mezz lenders will likely have a minimum equity commitment they require from the developers they lend to (usually between 5% and 10% 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, lenders will want to know that you also have money on the line should the project go sideways, so that you are not tempted to just walk away should the going get tough.
Equity, should you need to go to an investor to source it, will be the most expensive aspect of your capital stack. Often it is paid for by an interest rate and/or a profit share, which can be as much as 50% of your profit (after repayment of senior / mezzanine finance costs).
How to Structure Your Stack
The combination of senior debt, mezz 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
Project Costs (excluding finance costs) – £1,500,000
Developer Equity available – £400,000
Option 1 – Senior Debt Only
60% Loan-to-GDV = £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 – 60% Loan-to-GDV = £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 excluding finance = £700,000
Total Costs Including Finance = £750,000
Senior Debt 60% Loan-to-GDV = £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.