A Guide To Calculating Development Finance
Calculating development finance is a complex topic
Read this guide to demystify the process and make it more straightforward.
Development finance is a tricky topic that can be difficult for developers to understand. When securing property investment, you need to know how your loan will impact your project and its profits.
Much of a project is about debt and equity, balancing your own stake of equity against debt. Your equity is generally the deposit required by the bank to actually offer the loan, but can also be made up of private investments. Equity sits at the top of the Capital Stack and is the last thing to be repaid, making it the highest risk. To compensate for the risk, equity investors expect a share of your profit.
Debt is typically far preferable to equity investment because you can negotiate great debt loans that have affordable repayment periods and don’t incur the same penalties as private equity. By reducing the amount of equity you put into a project, you can free up cash to develop elsewhere and benefit from the stable repayment terms outlined by the lender.
But most property developers don’t realise any of this - instead favouring a combination of a lender’s loan at a low LGTDV and private equity investment to plug the gap. However, when you do that you’re giving away far more of your profits than you need to.
The capital stack
In our article about the capital stack, we explain the key layers (senior debt, mezzanine, equity) of how to calculate the ‘package’ or ‘stack’ of finance that contributes to your development. The bottom layer is your senior debt, which is contributed by the lender. This debt must be repaid first and is, therefore, the lowest risk for the lender. The mezzanine debt is repaid afterwards. Equity debt is the riskiest for investors so demands the highest reward, and is most expensive for you as a developer.
When a lender considers your project they’ll want a full overview of your capital stack so they can determine the hierarchy of your funding sources and weigh up the potential ROI versus their risk. This isn’t a thing unique to banks - private investors will also want to assess your funding sources.
Where ‘equity’ refers to personal and private investment that isn’t structured around debt and repayments but is instead tied to profit shares etc, ‘sweat equity’ is the level of investment you may have already put into the project. If, for example, you’ve already purchased the land or site and then secured planning permission, you have added value to the project already - so this added value can be considered part of your equity.
Lenders can have a wide range of attitudes to sweat equity, so it’s important that you find a finance partner who can secure a lender that allows you to use sweat equity to reduce your actual equity investment needs.
To put that in plain English: if you’ve already been working on a site and making it better, you need to find a lender who will account for that in the agreement so they either allow a lesser deposit or provide better terms.
For developers who own a site and have specific costs, such as security, etc., you can find lenders who will account for that in their calculations. For that reason, you’ll need to keep a strict ledger and record everything from maintenance to security and debt servicing.
Calculating development finance as a whole
With these factors considered, it’s time to actually calculate how you’ll finance the project. Debt is cheaper than equity in terms of cost to you, but many developers will instead think that low rates and larger deposits are preferable. If you do that, it means finding private equity from your own funds or from investors - all of whom will demand high returns due to the risk of equity investment.
Instead, you need to approach lenders with experience and authority. If you’ve already done work on a site, you have some inherent equity that you can use if you know how to leverage it. Your lender needs to be made aware of the value of your sweat equity and site costs so that they can adjust their offer. Your senior debt, or bank loan, will be the main source of funding - but it can also be a real boost to your overall profits if you can secure the right terms. Don’t be afraid to accept a higher repayment rate if it means reducing the deposit (equity), as repaying debt won’t eat into your profit like repaying equity investors will.
Ultimately, when it comes to securing your development finance and working out how to structure your funds, Rangewell can offer you free assistance which will be invaluable. We’ll work with you to assess your current equity situation and navigate the entire lender market to find the right loan terms that minimise your personal equity stake and make your development as profitable as it can be.
Get in touch with our team today and start maximising your development finance potential.