How to Access Higher Debt Amounts for Development Projects
Maximising return on capital in a project requires a certain amount of leverage. The ideal level will depend on the risk and profit margins held within a project. For higher returning projects and full-time developers looking to spread their capital across multiple projects, it can be beneficial to use higher leverage. This will result in a higher return on capital or "cash on cash", freeing up more capital that can potentially be used on other projects. Given that banks will generally cap out at 70% of Total Development Cost (TDC) or 60% LVR against on-completion value; a developer who wants to borrow 80-85% of TDC will need to either consider a mezzanine loan to sit behind a bank or a non-bank loan across the whole project.
Here are some of the pros and cons of each:
- Lower Cost of Senior Funding: This provides a level of de-risking in that the costs of delays and/or default will potentially be lower in a lower-cost senior facility.
- Relationships: Providers of mezzanine funding are often investors who will back developers they trust. Over time, building these relationships can make it easier to raise capital for future projects, whether through debt or equity.
- Two Lenders: These loans can be comprehensive regarding documentation, given that two parties must work together to approve the loan. There will typically be a deed between the two lenders confirming the amounts on the mortgage.
- Higher Legal Fees: Due to the more significant amount of documentation and potential negotiation between two lenders, there will be two sets of legal fees.
- Pre-sales Requirement: Given a bank will provide the senior funding in this scenario, it is likely that at least 100% debt coverage on the senior facility will be required. This is often difficult to achieve, particularly in the current market.
- Straight Forward Documentation: Dealing with just one lender is simpler and means less documentation, reducing legal fees and speeding up the process.
- Lower Pre-sales Requirement: Without a bank involved in the process, a lower pre-sales requirement; therefore, higher gearing can be achieved.
- Cost of Funding: Overall cost of funding may be higher using a non-bank lender due to the significant difference in costs of capital between banks and private funders.
- Higher Default Costs: Senior facility at a higher rate, events of default may cause a much higher penalty, particularly later in the project when senior debt approaches the limit.
- Funding Risk: Non-Bank market for development funding is largely unregulated, some funders are less reliable than others and issues can arise in the capital raising stage. You should be careful in dealing in the non-bank space, that you only deal with reputable companies.
Funding a project at higher leverage using either bank and mezzanine funding or non-bank senior development funding both carries risks and benefits to be considered. The project's specific details and the developer's risk tolerance will determine the correct course of action. Having a good team of trusted advisors around you is important when determining the best way to fund a project.