Raising a hefty deposit is often a thorn in the side for developers, whose equity provisions may not stack up against their ambitious development plans.  With different types of lender requiring varying deposit percentages, and even the same lender looking for different deposit amounts from site to site, it’s a delicate balancing act that many developers simply don’t have the time or patience to juggle properly.


Taking a broader view

The tendency when it comes to development finance, is to default to tried and tested senior lenders, but the deposit requirements vary hugely from 10% to 20% of total costs (including land, build, finance and professional fees).  On a scheme with costs of £6m, the required deposit could therefore be anything from £600K to £1.2m; a huge difference and potentially a make-or-break variance.  If the developer only has a relationship in place with a lender at the higher end of the scale, this extra £600k deposit could mean they have to pass on a future opportunity, creating a significant opportunity cost.


Equity is always more expensive than debt. Whether you’re talking in real, financial terms, or the opportunity cost of tying up more equity in a project than is needed.’


It’s unlikely that using one source of development finance is the most cost-effective route. Most developers will introduce other partners to a scheme, perhaps friends, family or people in their wider network.  SMEs, particularly new ones, often struggle with raising equity and securing development finance.  Similarly, corporates are more likely to work on a joint venture basis to help boost their equity, so following the example above, a developer may put in £600K of their own money and raise £600K from an additional investor to whom they pay profit share.


‘Cheap development debt is almost always a false economy. Developers need to be smarter. They need to realise their most precious resource is time, shortly followed by their own equity’.


To put this into context, let’s say there is a site that has combined land and build costs of £6m. The GDV is £9m and the build term is 12 months. The exit is sale of the units, therefore we take an 18 month loan term so we have 6 months to sell the units.

Developer A uses a well-known high-street lender to provide their debt. The rate is attractive at circa 5%, but they are required to invest £1.2m of equity (20% of costs). Developer A puts in £600k and their investor puts in £600k. They pay their investor 5% interest and 40% of the profit. Lender costs are £400k, taking total costs to £6.4m. Profit is £2.6m, so the investor is due £1.04m (40%). Developer A makes pre-tax profit of £1.56m in 18 months. Very good.

On the same scheme, Developer B takes the time to search the entire market and finds a different lender. This lender charges 7.5% for the debt, so a slightly more expensive rate, but they can borrow £600k more. Developer B doesn’t need an investor and doesn’t need to give 40% of their profits away. The cost of the debt is £600k, so total costs of £6.6m. Profit is £2.4m, but there is no profit share*. Developer B earns £840k (pre-tax) more than Developer A in the same period of time. The only difference is Developer B has shopped around for his funding.


‘When you’ve spoken to as many developers as we have, you start to realise the differences between them. A developer’s network and their ability to find deals and the right personnel to work with them is critical.  But in our opinion the fundamental difference between average developers and great ones, is their ability to make debt work for them.’


Structuring your debt

The key to stretching your equity further is to determine the best capital stack for your project; essentially the different layers of finance, which become the building blocks for your funding.  As well as providing you with increased flexibility with your own equity, and the potential of greater subsequent profits, investors are also able to see where they fall in the hierarchy of cash flows.  This determines the level of risk, and ultimately helps them decide whether the ROI is worth the associated risk.


Typically, a capital stack has three tranches, and the higher positions in the stack earn higher returns due to their increased risk.  Those at the bottom of the stack are repaid first, so any losses are incurred from the top down.  How you structure your allocation of equity and debt should be determined by your investment objectives, so a strategic approach is a must.



Keeping cash as king

So, how can you utilise the capital stack to stretch your equity further?  Essentially, it’s about keeping your cash as a last resort.  As well as shopping around for different lenders, experiment with different loan structures.  Consider senior, stretched senior and mezzanine, which can be combined in many different ways to allow you to minimise the equity you invest.


Taking the time to shop the market and play around with different debts can help you create the optimum capital stack, maximising profit and ultimately optimising your equity deployment.


In our next blog, we’ll be looking at three more ways to conserve your cash and make your equity go further.


If you’d like to discuss your capital stack, or for more general development finance advice, please give us a call on 02078410184 or email info@propertyfinancegroup.com



*The figures in the worked example are for illustrative purpose only, and not an actual case study.