Property development funding comprises different layers of finance, typically known as the capital stack. Most property developers and investors buy an asset using a combination of equity and debt. The funding spectrum ranges from purely equity at one end and purely debt at the other. How far you go towards one end of the spectrum or the other determines your returns, in a linear fashion. The higher the risk, the higher the ultimate returns, all things being equal.
In the capital stack the most expensive slice of finance is equity. Debt will likely be secured against the underlying property by way of a charge. This provides downside protection – should anything go wrong, the debt is usually the first in line to repaid. The amount of protection usually depends on the loan-to-value (LTV) ratio. The higher the LTV the higher the protection.
In comparison, equity is usually the last in line to be repaid or is the first to get wiped out depending on how you look at it. Thus equity is the riskiest element in property development funding. As a consequence, equity ‘costs’ the most – the developer will have to reward equity providers with either a chunk of the end product or by offering a return on interest way higher than that of debt.
Of course, the developer can minimise the 3rd party equity contribution of the capital stack by using more of their own funds from the beginning. This depends on them having the money to hand in the first place and means they have less capital available to dedicate to other projects. In other words, the more equity the developer contributes the greater risk they assume.
The Equity Component
The purpose of this article is not to speculate on what the correct balance of debt or equity might be for a project. That will depend on many variables and ultimately there is no right or wrong answer. Rather, it takes a closer look at the equity component of the capital stack.
It’s incredibly rare for a debt provider to cover 100% of any property development funding. This means a developer – otherwise known as the Sponsor, Operating Partner, or General Partner (GP) – will need equity in any deal. As mentioned above, this comes directly out of their own pocket or more likely syndicated amongst “friends and family” or some other 3rd party supplier. Professionally speaking, the 3rd party/parties would be called Limited Partners (LPs).
The relationship between the developer and the LP is often confused with other terminology such as joint venture. At the end of the day, it’s the same concept; the developer brings the deal and oversees or conducts all the work, and the LP brings the capital which allows the developer to scale his development business.
Factors such as a developer’s experience and size will determine the types of LP capital he will be able to raise. Newer developers have less reputation and less negotiating power, so will usually turn to less sophisticated investors, or friends and family. More experienced developers will easier raise capital from professional investors such as Family Offices and institutions. The structure or composition of the developer’s contribution will also typically depend on his track record.
Textbook developer contributions may range from as little as 5 percent of the equity up to 20 percent. This will be in exchange for a disproportionate share of the development’s profits, also known as a “promote”. Promote structures range from simplistic 50/50 profit splits to more rewards-based calculations based on hurdles or “waterfall returns”. These waterfall returns allow for the developer to gain additional disproportionate profits from a successful deal after targets archived.
With debt financing becoming more and more difficult to find in these challenging markets, the demand for equity has grown. So too has the appetite for junior, or mezzanine debt to replace some of the more expensive equity. Junior debt sits behind senior debt in the repayment structure and hence will charge a higher rate of return. It will be more ‘expensive’ to the developer. Furthermore, it will carry additional legal costs, set-up time, and most often a second charge over the asset. Many senior lenders do not like or care to structure this way, especially at lower deal sizes. Raising LP equity, structured in the right way, can negate the need for junior debt and so alleviate associated headaches.
As already said, there is no right or wrong way to structure your capital stack. But you must make sure the solution works for you in terms of the balance between risk and reward. Your track record, the deal itself and your ability to navigate through the different sorts of capital providers drives your property development funding.