Capital Stack for Commercial Real Estate Finance & Property Development
An understanding of your capital stack is vital for a successful property development scheme.
Learn more about how your capital stack impacts your property development project here at Rangewell and secure a reliable broker partner to help fund your project.
When you’re planning a property development project, your capital stack is going to impact how you make financial decisions and how your lenders consider your application. The capital stack is a financial term that describes the ‘stack’ of development finance layers that fund your real estate property scheme. Essentially, it’s the ‘finished’ fund made up of capital contributed by all sources and it defines the rights and order around who receives income and profits from the property.
Typically, a stack consists of three layers that are usually senior debt, mezzanine debt and equity. The structure of your capital stack will affect your investors and your own profits and will ultimately decide how lenders approach you. All lenders will want to understand your capital stack as it helps them understand their position in your hierarchy of funding, which allows them to assess their potential ROI versus their risk.
Commonly, your capital stack can be made straightforward by considering it as your bank loan/mortgage (senior debt) and your own investment in the project (equity). If a lender requests a large deposit for a property, as they have assessed a high level of risk, for example, you can either supply your own equity or reduce your exposure by bringing in other investors on an equity or mezzanine debt basis.
The bottom of a capital stack, known as ‘senior debt’ or 'senior loan', represents investors who are senior over everyone above them in the capital stack. This means they will receive repayments from their investment through interest and principal before any other investors in the stack. When your property development is sold, these same investors will be the first to be paid in any outstanding principal and accrued interest. This is often the first mortgage/bank loan you take out.
Senior debt investors also have more authority around liquidating property and resecuring their investment should your property fail to perform to expectations. Once your failed property is sold they are the first to be repaid.
This security means that Senior Debt holders typically receive the lowest return on investment but have the most access to cash flow and collateral - so essentially they have the lowest risk compared to everyone else.
When you’ve secured senior debt in the form of a mortgage or bank loan and already have common equity but still can’t afford your project, you need mezzanine finance. The Mezzanine debt is made up of hybrid investments and is subordinate to the senior debt from a mortgage. It is not secured by your property - instead mezzanine loans are generally given against a pledge of equity in the company that owns the property development. In those instances, if you default, the mezzanine lender can then become the owner of the pledged company.
Ultimately mezzanine debt takes its name because it blurs the line between equity and debt. It has a repayment structure and is often used to alleviate some of your own equity investment.
If you were to buy a £1 million property, for example, you could have £600,000 from the bank and £400,000 in common equity - but by bringing in a mezzanine debt investor for £200,000 you then have to contribute just £200,000 in equity to maximise your return on equity. It all depends on your circumstances, level of risk perceived by the lender, project costs and potential returns for investors, among many other factors.
Common equity holders are those most at risk when investing in your property development project - they are repaid last. To alleviate this, they demand a higher return on investment to allow for the risk. It is the classic ‘high risk, high reward’ investment tactic and one that makes sense in property because unlike debt investors, common equity holders gain from appreciation in value. Common equity investors are buying into your project and ‘owning’ part of it, rather than simply financing your development.
Preferred equity is similar in concept to preferred shares in the stock market - in that as a developer, you can entice investors with preferred equity. This is more expensive than senior debt and riskier because it is exposed to the value of the property. As a result, interest paid is higher to preferred equity investors but there is not usually any profit share.
How does your capital stack affect your property development project?
As we’ve mentioned in some of those explanations, reducing your own equity can be a beneficial way to improve your returns. By minimising equity and securing the right financing options, you’ll simply be paying back debtors and not having to share profits. The more equity investment you have, the more ‘share’ of the actual property you’ve given over.
Debts are repaid from the bottom of the stack to the top and equity is always the highest (and last to be repaid) - but some capital stacks won’t contain preferred equity or mezzanine debt. Reducing your own equity in a real estate project frees up funds for other developments and helps keep the return on equity in a positive direction.
For property developers, remember that the most significant margins you make are shared with equity investors - you’ll have to create a profit share agreement in order to get their investment. That means it is often better to choose a loan for your senior debt which may be at a higher rate but require less of your own equity and therefore minimise the need for private equity investment. That said, if you don’t have the funds for a deposit, private equity investment may be the best route.
Navigating your capital stack and selecting the ideal finance solutions can be difficult. Why not work with Rangewell?
We’re an independent broker with a proven track record of working with leaders in the real estate industry. We know the commercial property market inside and out and can help approach lenders across the whole of market and advise you on the best finance options for your next property development project.