How property development finance works

Every homeowner understands the difference between their mortgage and the equity they have in their home but when it comes to commercial real estate transactions like property development finance, the difference between equity, preferred equity, mezzanine debt and senior debt can confuse even the savviest financial minds.

Let’s take a look at what’s called The Capital Stack to better understand where the different types of finance sit in a commercial property development.

The Capital Stack for property development finance

Senior Debt

Senior Debt is secured by a First Mortgage on the property itself, so if the borrower fails to pay the lender can sell the security property. This greatly reduces risk on the principal invested because, at worst, the lender can recoup its principal by selling the property.

Mezzanine Debt

Mezzanine Debt sits behind the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called a Priority Deed, where they spell out how their rights interact (i.e. what happens if a developer stops paying both of them).

Preferred Equity

Preferred Equity is perhaps the hardest portion of the capital stack to speak about generally because, for better and worse, it’s very flexible. Preferred equity holders have a preferred right to payments over regular (common) equity holders. “Pref” equity positions range from “hard” preferred equity, which function similarly to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or kick out the developer if they fail to make payments, soft preferred equity holders typically have more limited rights.

Common Equity

Common Equity is the riskiest and most profitable portion of the real estate capital stack. Typically the developer (or sponsor) will be required – by the lender and/or by other equity investors – to invest their own money as some portion of the equity to have skin in the game. Equity investments carry the greatest risk, because investment agreements entitle every other tranche of capital to be repaid before common equity holders. However, if the property development does well equity investors usually receive an exceptional rate of return. This is because they receive a portion of profit which can easily outstrip the return paid to debt holders usually expressed as an interest rate.

For example, a sponsor may have sourced senior finance at 6% per annum, mezzanine finance at 22% per annum but the sponsor and common equity holders return on investment is 50% per annum. Another way to think about it is that common equity is very expensive when compared to debt within the capital stack.

Understanding the stack is incredibly important as certain lenders will only become involved in particular types of property development finance and interest rates will vary depending on the risk. Currently, Private Mortgages Australia provides Senior Debt and Mezzanine Debt, and have aspirations to offer Preferred Equity in the future.

If you’d like to discuss finance for your next property development project then please get in touch.

Funding options for settling a development site

Funding options for settling a development siteIn this guest post, PMA referrer, Dan Holden, Director of HoldenCAPITAL, writes about the benefits of using private capital to settle a development site.

Banks are very reluctant to get involved in lending against development sites. Some developers were getting sites funded as house investment loans because there was an existing house on the land they were purchasing. This was all too common until 2015, when the valuation industry was ordered to make a note wherever they thought the purchase was actually intended for a development project rather than a passive rental return house. The heads up from the valuer to the bank resulted in loans being declined if the bank believed it was for a development project.

Some of the reasons the banks are so reluctant to lend against a development site include:

  • An inability to prove the borrower can service the monthly interest, usually requiring 1.5 times interest cover from recurring income.
  • The main exit strategy is via a construction loan, which the banks are now only doing on a selective basis.

Banks take a view that they will only lend up to 75% of total development cost for the construction loan, and the land in a development project should typically takes up less than 20% of the total development cost. If they were to advance monies against the land, then they are reliant upon the developer putting in further cash to actually convert it into a construction facility. Being reliant upon a developer to find more money down the track is not a palatable credit answer. To put that in numbers, if you had a $10 million TDC project and the land was $1.8 million, the bank is only going to lend you $7.5 million to build the project. So if you don’t have $2.5 million now, they won’t rely on you finding it under your pillow in six months’ time.

We have seen a rise in developers using private capital to get these loans completed quickly and without the fuss of proving serviceability or an exit strategy. The cost of capital is higher at 15%p.a. however, at a lower LVR and/or with a robust sponsor we have been able to secure 12%p.a. While 15%p.a. sounds high, it is typically just for 4-6 months while the developer finalises his BA and any marketing, so the overall burden to the project is fairly insignificant. It is also better than using cash for that period and if you’re an elite property developer, you would want to see your cash invested at better than 15%p.a.

Dan Holden is Director of Holden CapitalDan Holden – Director, Holden Capital

HoldenCAPITAL is a specialist construction finance group, recognised as a market leader through its successes in deal structuring and the sourcing of debt and equity solutions.

Dan has over 13 years of development and finance experience which includes over six years in finance consultancy and funds management. You can contact Dan at [email protected].