The three most important elements that must come together to be a successful property investor is the deal itself, the knowledge of how to add value and finally having the capital available to transact.
We will focus on having the capital available to transact and more specifically, the capital stack and the important aspects to consider when borrowing capital or investing into a project such as security of your money, the level of risk involved and the projected returns.
Whilst carrying out thorough due diligence will ensure you assess the viability of a project, the capital stack allows you to establish the layers of investment required to fund the project and make it work.
What is the Capital Stack?
The Capital Stack is the structure of total capital used to fund a property development or investment whereby a hierarchy of creditors are listed in ascending order in the event of a loan defaulting.
Consisting of Common Equity, Preferred Equity, Mezzanine and Senior Debt finance, each level of the stack comes with different risks for the lender/investor and therefore different costs associated. In general, each level has seniority over all the capital sources located above it in the stack and is subordinate to all of the forms of capital below it.
As a property developer or investor, determining the best capital stack for your project allows you to fine tune your overall cost of capital, minimise your equity investment and maximise your returns.
Understanding each layer of the Capital Stack
Senior debt is always at the bottom of the stack and can make up up to 75% of total costs of the project.
It has the highest priority against the security provided and is the cheapest part of the capital stack because it comes with the lowest risk (the lender can take over the property and sell it to recover their debt if something goes wrong).
Senior debt is usually paid for by a combination of arrangement fees, exit fees and interest. The rate of interest can range depending on what type of asset you are securing the debt. For example, commercial loans can range from 3% to 6%. Development and Bridging finance, however, can be between 4% and 9% depending on the leverage.
Mezzanine debt, also sometimes referred to as Junior debt, on development finance can take your capital stack up to either 75% loan to GDV or 90% loan to cost. On commercial term loans it is possible to stretch to 85% Loan To Value (LTV) in some instances.
Mezzanine debt is usually secured with a second charge and is higher risk than senior debt and as such, the projected returns tend to be higher.
As it is positioned above senior debt in the stack, if a lender invests in your project via a Mezzanine finance facility and the loan defaults, the lender will only receive any disbursements after all of the senior debt has been paid off.
Mezzanine debt can cost between 15% and 20% pa in interest along with entrance and exit fees due to the greater risk involved for the lender.
Some lenders will also offer Stretched Senior debt. This consists of securing senior and mezzanine debt from the same lender and is paid for with a ‘blended’ interest rate, this could be 8% to 12% for the debt up to 75% loan to GDV (LTGDV).
At the top of the capital stack is equity, the most expensive layer of finance. Preferred and Common Equity both give borrowers more access to equity capital, therefore, allowing the developer to “unlock” the final piece of the jigsaw to make a capital stack whole.
With equity, the source of capital can either be all your cash or a combination of cash from you and an investor. You use Equity Finance so that you don’t have to inject all of your own cash into your next investment. It is worth noting that equity is typically the hardest part of the capital stack to source and secure.
Outside your own pool of cash, the source of Equity Finance ranges from High Net Worth Individuals and Family Offices to Private Equity Institutions and these days Crowdfunding platforms. Needless to say, the more equity you have, the more deals you can do and the quicker your business will grow.
Preferred Equity, also known as 3rd Party Equity, is most commonly used where additional funds are needed beyond what senior or junior debt can provide. Preferred equity receives a higher rate of return than any debt piece of the stack and a lower return than common equity, which is relative to its risk.
Common equity is often referred to as “having skin in the game”. This source of funding typically comes from the developers, sponsors of the property/project, and/or joint venture partners that invest in the project with either sweat or capital.
While common equity typically involves more risk, it also offers a higher potential return than preferred equity. Common equity holders receive a pre-agreed distribution of the remaining cash flow or value once the senior debt, mezzanine and preferred equity is repaid.
Equity is paid for by a combination of interest, arrangement fees, exit fees and/or a profit share, typically 50% of profits. Both the senior lender and mezzanine lender may have a minimum equity commitment they require from a developer/investor which could be between 5% to 10% of the total costs of the project.
Using the Capital Stack
Each level of the capital stack comes with different risks and rewards and lenders/investors in your project will have different requirements, costs, maximum leverage limits, security packages and, in some cases, minimum return hurdles.
Given this, it is important to have a broad understanding of the finance options available to you before deciding which route of finance to go for.
Where you position yourself in the stack depends on the level of investment you find appealing, your personal financial circumstances and your appetite for risk.
If you are keen on being a capital provider/investor instead of a property investor/developer, it is wise to diversify your portfolio and spread your investments up and down the capital stack with numerous projects. In this way, it is possible to reduce the overall risk exposure and maintain long-term appreciation.
If you are not sure how to use the capital stack within your property business, our Property Funding Advisers are happy to help. We can assess your current situation and guide you through the funding process to help you meet your property business goals.
Schedule a strategy call below to find out more.
Your property may be repossessed if you do not keep up repayments on the finance secured against it.