Cracking The Capital Stack

All you need to know about The Capital Stack. Includes: what it is, how it works in practice and the differences between mezzanine and equity finance.

What is The Capital Stack? 

The Capital Stack refers to the structure of development finance, or the different layers that fund a property development or investment scheme. 

The typical stack has three main layers, including:

• Senior debt: The bottom layer that makes up the majority of the funding stack; the lender has first-charge.
• Mezzanine debt: A smaller, second-charge middle layer that tops up senior debt and reduces equity.
• Equity: At the top of the stack, equity is the final layer to complete the full debt structure. It can be made up of equity finance/preferred equity and common equity.

Not every stack has to have senior, mezz and equity. Mezz is optional. It can have all three, only senior and equity, or no debt, just pure equity. Some transactions have no room for mezzanine finance – senior finance can be available up to 90% of costs and 75% of GDV, and mezz tends to cap at 75% LTGDV and 90-95% of costs. Therefore, if there’s a stretched senior debt position, it’s likely that the only option above that is equity.

Strategically determining the best capital stack for every project is crucial to minimise equity investment and maximise profits.

Key components of the capital stack - what you need to know

Debt Repayment Hierarchy: Debts are repaid from the bottom up, i.e. the senior debt lender is repaid first. The higher the lender is in the stack, the greater the risk and, consequently, the more expensive the debt.

Equity Position: Equity always sits at the top of the stack, above any second-charge debt, meaning on project completion and sale, equity is only recouped after all other debts are paid. 

Stack Visibility: Lenders will evaluate your capital stack to understand their position in your funding hierarchy. This assessment helps them determine potential ROI against the level of risk.

What is senior debt?

Senior debt is the main development finance package that funds a property development scheme and is secured against the property/site. It’s arranged through banks, non-banks and specialist lenders.

As the primary source of funding, it partially covers site costs and can cover up to 100% of build costs. Typically, development finance is limited to a maximum of 75% loan to gross development value (LTGDV) or 90% loan to cost (LTC).

The senior debt lender holds first-charge against the scheme, so they are prioritised for repayment on project completion and sale/refinance. Or in the event of a default, they will recoup their debts first from any repossession proceeds .

What is Mezzanine Finance?

Mezzanine finance is a secondary, smaller loan that is used to plug any funding gaps between senior debt and equity contribution.

For example, if the development finance loan covers 70% of the total costs, rather than a 30% equity contribution, mezzanine finance could cover 20%, leaving just a 10% deposit requirement. Typically, mezzanine loans go in on day one, alongside the main borrower's equity. 

Mezzanine lenders tend to be:

• Individuals
• Family offices
• A pool of multiple investors
• Asset managers
• Private equity firms
• Entities with institutional capital and/or larger backers

(Note: These lenders tend to be more comfortable sitting higher up the risk curve compared to mainstream banks.)

As the second-charge loan, mezzanine lenders are only paid after the senior debt is repaid in full, but before the borrower can extract any profit. The senior lender has to consent to the mezzanine lender being involved and both lenders need to agree to an Inter-Creditor Deed (ICD). This governs the rights of each party in the event of default.

ICD’s can take time to negotiate, but where the senior and mezz lenders have worked together before, the ICD will already be in place, supposedly leading to a more efficient process

Mezzanine finance will carry higher interest charges than any first-charge borrowing, with interest rates of between 15% and 25% typical, and arrangement and exit fees of around 2% each.

Benefits of Mezzanine Finance

• Reduces capital requirement, increases leverage: Whether a property investor/developer is short of equity, or simply prefers to diversify their capital, mezzanine preserves cash, facilitates further borrowing and potentially enables simultaneous investment elsewhere.

• Increased Return on Investment (ROI): Achieves the same profit outcome (less mezzanine debt costs) but with a much smaller equity input.

• No duplicate valuations: Mezzanine lenders typically accept the valuation and surveyors report prepared by the senior debt lender. There will normally be a smaller fee payable to the valuer, so that the mezz lender can rely on their report.

• More control: Unlike equity financing, which involves a profit share, mezzanine finance is normally cheaper, and doesn’t dilute ownership, enabling the developer to maintain control of the project throughout.

Drawbacks of Mezzanine Finance

• Higher interest rates: More expensive than senior debt due to its higher risk
  
  
• Complexity: Arranging mezzanine finance involves dealing with multiple lenders and legal teams (the mezz lender will have separate legal representation to the senior lender, and the borrower covers the cost). Open and transparent communication between all parties is key.

• Availability: Not all senior debt lenders will accept additional second-charge loans on the scheme, and likewise, mezzanine lenders often limit product availability to experienced developers, with a clear portfolio of previous successful projects.
  
  

What is Equity Finance?

Equity involves raising capital from an investor(s) in return for a profit share. Some investors might charge an annual interest rate on top and receive fixed returns, making it a kind of hybrid of both debt and equity. In exchange for their stake in the project, equity investors take on some of the risk.

Equity investors typically include: 

• Family offices
• Investment professionals
• Private equity firms
• Crowdfunding platforms/P2P (peer-to-peer lending)
• HNW (high net worth individuals).

The total equity contribution in a project can include equity investors and the developer’s/main borrower’s own capital (common equity). All senior debt lenders prefer to see some ‘skin in the game’ from the borrower, so if raising third-party equity, it’s crucial to know what equity contribution the senior (and mezz) lender(s) are happy accepting from the main sponsor.

In the capital stack, equity sits at the top, and is therefore repaid last. However, professional investors in this space will typically command ‘preferred equity’, meaning they are repaid after all debt but before the borrower. Where the borrower sources funds through their own network, i.e ‘friends and family’ arrangements, the investors might agree to an equal footing with no preferred equity stake.

Equity investment represents the highest risk amongst investors, but also potential for more significant returns.

Benefits of Equity Finance

• Reduces capital requirement, increases leverage: As with mezzanine finance, adding equity finance to the capital stack can significantly reduce entry capital, preserve the borrower's cash and facilitate further investment.
  
  
• Shared Risk: Investors share the risk as well as rewards, which means any losses are shared, reducing the financial burden on the property developer.

• Expertise: Professional equity investors often have extensive experience in property development, with a strong network across contractors, architects, planning consultants and other professionals, which they can leverage if needed to help the project succeed.

Drawbacks of Equity Finance

• Dilution: Some equity investors may want a say in the project, or insist on controls that they can use if they feel the project isn’t performing.
  
  
• Cost: The cost of equity is often higher in terms of the percentage of profits shared with investors compared to debt finance. 

• Availability: As the highest level of risk, equity finance is less accessible than debt financing.

However, if the scheme has a particularly high profit margin, and the developer is contributing a good chunk of their own money, there will likely be more investors available and the cost of the equity will fall.

Mezzanine Financing vs Equity Financing

Typically, debt financing like mezzanine is easier to obtain than equity investment and likely to be cheaper. 

On the other hand, equity finance offers access to larger amounts of capital, with shared risk in the project and potential access to expertise. However, it involves selling a stake in the project and profit sharing.

Both are beneficial in reducing capital contribution, increasing returns and facilitating more leverage.

Before procuring second-charge loans or investor input, the senior debt needs to be arranged first. Mezzanine lenders or equity investors need to know all the costs involved in the scheme, including the costs of funding, to understand exactly how much is needed and provide an accurate quote.

Practical considerations

Deposit range

Not all lenders require a huge deposit. Shopping the market uncovers better deals, with higher net loans that preserve borrower equity. Borrowers who always default to their trusted lender are significantly disadvantaging themselves and their business.

Deposit requirements for senior loans can vary from 5% to 45%, which creates a huge opportunity cost from lost equity if the loan deposit is at the higher end.

When a lender requests a large deposit, securing equity finance on a profit share basis is a natural route to go down, but this can prove a false economy. Debt is cheaper, so maximising this element of the stack, before you go to mezz and equity is normally beneficial. Any property development scheme wouldn’t get off the ground without the drive of the property developer - it’s important to remember that when negotiating the terms of the profit share.

Here’s an example:

• Developer X’s Approach:
  • £2m project costs, at 60% LTC
  • Borrows at 8% interest but needs to put down £800,000 in equity.
  • Developer X only has £400k, so secures £400k from an investor
  • 12 months later, the scheme completes and he pays the 8% interest and gives the investor 40% profit
    
    
• Developer Y’s Approach:
  • £2m project costs, at 80% LTC
  • Finds an alternative lender, with a higher rate of 12% interest, but provides £400,000 more in borrowing.
  • By securing a higher net loan amount, Developer Y pockets all project profits and has £400,000 available for future investments.
  • Whilst paying a higher interest bill, Developer Y, is better off because the higher debt cost is more than offset by not paying a profit share.

Optimising the capital stack

The best capital stack structure starts by working from the bottom up. Securing the right senior debt, with a higher loan to cost can enable you to leverage better second-charge financing and leverage better deals with less profit share for equity investors. 

However, in today’s market, even with the highest net loan available, many property developers and investors still have a significant shortage in equity. As we previously discussed, higher interest rates are creating a liquidity crunch that’s curtailing property investment. 

Despite the recent rate drop, and predictions of further decreases, interest rates are still around 5% higher than where they were a couple of years ago. That equates to £50k per year extra in interest charges per £1m of borrowing, which has to come from the borrower’s piggy bank.

Topping up equity with second-charge financing optimises the capital stack, increases ROCE/ROE (return on capital employed/return on equity) and can facilitate more investment.

A worked example by Deallocker shows how mezzanine finance can free up £1m in equity and improve ROE:

The deal’s ROE increases to 9.75% compared to 9.17% without mezzanine financing.

Minimum entry equity

Most senior lenders will insist on a minimum equity contribution from the main developer/borrower, so it’s not possible to borrow 100% of the deposit. This minimum level will depend on the specifics of the project and the borrower.

This lending criteria is often missed by borrowers and intermediaries, meaning time is wasted procuring mezzanine finance that isn’t compatible with the senior debt.

At Brickflow, to prevent this situation, when development finance lenders provide a DIP on our platform, they must provide a figure for the minimum equity requirement from the main borrowers.

Final thoughts

At Brickflow, we’ve been hearing about the problems caused by the liquidity crunch from our intermediary partners for some time now, and therefore understand the need to plug the gap.

Enabling intermediaries to secure all layers of the capital stack, easily and in a connected journey can overcome the equity problems faced by borrowers. Our partnership with Deallocker now means brokers can secure a client DIP on Brickflow, then seamlessly invite investor bids from second charge lenders on the deal - completing the capital stack in a matter of clicks.

Brickflow is now trusted by over 200 intermediaries as the quickest, most efficient way to secure the best specialist finance for their clients. Request your free trial today to see how you can benefit from our award-winning tech.

For borrowers looking for more information on bridging loans, commercial mortgages and property development finance, you can connect with one of our specialist intermediaries, or email us on info@brickflow.com.