Understanding the Capital Stack

The capital stack describes the layers of funding that finance a development project. Think of it as a vertical structure where each layer has different characteristics in terms of risk, return, and priority of repayment.

At the bottom of the stack sits senior debt, the most secure form of lending. Above that sits mezzanine debt, which fills the gap between senior debt and equity. At the top sits the developer's own equity contribution. Each layer up the stack carries more risk and therefore demands a higher return.

Understanding the capital stack is essential for developers because it determines how much of your own money you need to invest, what your total cost of finance will be, and how profits are shared upon completion. Different structures suit different projects and different developers, and getting the mix right can be the difference between a successful project and a marginal one.

Senior debt is the primary development finance facility that funds the majority of the project costs. It sits at the base of the capital stack and has first priority over the asset in the event of default. This security position means senior debt carries the lowest interest rate of all the capital stack layers.

Typical senior development finance characteristics include loan to cost ratios of up to 65-70%, interest rates from 0.65% to 1.0% per month, arrangement fees of 1-2%, and terms of 6 to 36 months. Senior debt is drawn down in stages as construction progresses, verified by an independent Monitoring Surveyor.

For Hackney projects, senior debt is available from a wide range of lenders including challenger banks, specialist development lenders, and institutional funds. The competitive lending market means that well-structured, viable schemes can attract very competitive terms.

Mezzanine finance is a second-charge loan that sits between senior debt and equity in the capital stack. It allows developers to reduce their equity contribution by borrowing an additional layer of debt on top of the senior facility.

For example, if senior debt covers 65% of total costs and the developer has 15% equity, mezzanine finance can fill the remaining 20% gap, bringing the combined LTC to 85% or even 90%. This dramatically reduces the amount of the developer's own capital required.

Mezzanine finance is more expensive than senior debt, typically carrying interest rates of 1.0% to 1.5% per month, reflecting the higher risk position. An intercreditor agreement between the senior and mezzanine lenders governs the relationship and priority of claims.

In Hackney, mezzanine finance is particularly useful for developers who want to take on larger schemes without tying up all their capital, or who want to run multiple projects simultaneously by spreading their equity across several developments.

Developer equity is the capital that the developer contributes from their own resources. In a standard development finance structure, this represents 30-35% of total project costs. However, through the use of mezzanine finance, this can be reduced to as little as 10-15%.

For developers who want to minimise their cash contribution further, joint venture (JV) equity structures are available. In a JV arrangement, an equity partner provides the developer's share of the capital in exchange for a share of the profits, typically 30-50%.

JV equity can fund up to 100% of the developer's equity requirement, meaning the developer can undertake a project with little or no cash investment. However, the profit share means the developer's absolute return is reduced, even though their return on equity is theoretically infinite.

The right capital structure depends on the developer's circumstances, risk appetite, and the specific project. We work with our clients to model different scenarios and identify the optimal structure for each scheme.

Selecting the optimal capital stack requires balancing several factors:

Cost of capital: Each additional layer of debt increases the total cost of the project. A developer with sufficient equity may achieve a better absolute return by using senior debt alone, even though they are investing more of their own money.

Return on equity: Using leverage (additional layers of debt) reduces the equity required and therefore increases the percentage return on the developer's investment. This is important for developers who want to maximise their capital efficiency.

Risk tolerance: Higher leverage means higher total finance costs and less buffer if things go wrong. A more conservative developer may prefer a lower LTC with more equity, while an experienced developer comfortable with the risks may optimise for maximum leverage.

Project scale: For larger projects in Hackney, such as multi-unit schemes in Dalston or the Haggerston, a blended capital stack with senior, mezzanine, and potentially JV equity may be the only way to access the capital required.

Our role is to help you understand these trade-offs and structure the capital stack that best serves your project objectives and personal financial circumstances.