Even before the release of the Hayne Royal Commission report, there was an explosion in non-bank lending to property developers. The non-bank lending market comprises alternative asset managers (private equity funds), family offices and even superannuation funds (for large projects). Compared to retail banks, non-bank lenders typically have a more pragmatic approach to investment and risk assessment. This market segment is largely unregulated and faces less red tape. Non-bank first mortgage debt as part of a project capital structure is now common and with new entrants in the market, rates are becoming increasingly competitive.
“Alternative” capital sources as part of the capital placed into projects is also increasingly popular (particularly for commercial project developments); including equity derivatives (forward sales, call and put options etc), preference equity and subordinated debt. This is a significant shift for an industry where commercial bank debt and syndicated ordinary equity is the well-worn path. Relative to this traditional syndication model, alternative capital structures generally share two common characteristics:
- Capital sources such as preference equity and subordinated debt are often secured and interest bearing whereas ordinary equity has risk sharing characteristics (for both equity value and return on equity); and
- the project capital structure includes much higher financial leverage (sometimes >95%).
With an interest bearing capital structure it is critical for both investors and the developer to acknowledge that there two sides of the financial leverage equation. On one side, the benefits of financial leverage (mainly that the developer holds 100% of the project equity and investors have a perceived security position) are what is attractive about alternative project funding solutions. If the project is delivered as planned, an interest bearing capital structure sees a greater portion of the development profit in the developers pocket and investors receive their agreed fixed return. It is the hallmark of a good deal – everyone is happy.
The flipside isn’t so rosy. Real estate is no different to any other asset class. The more financial leverage that you apply to a project, the thinner the equity layer is in the project’s capital stack. This results in greater variance in potential investment outcomes for equity holders (the developer) and capital providers more generally (investors). Anyone who has traded shares on margin account, CFDs or currency will attest to this. The fundamental difference between property and these highly leveraged asset classes however, is liquidity. There is no stop loss for a highly leveraged real estate transaction. This means that if the project is not delivered as planned, the security position of subordinated debt and/or preference equity holders can quickly evaporate (akin to the losses of CDO arrangers like Citigroup, Merrill Lynch and UBS during the GFC). So, while these capital holders have theoretical security in the form of the developer’s margin, when they look to rely on this security (when things aren’t going as planned) they find that they are actually exposed to the same risks as equity holders, being development risk. Ironically, this is the very risk that they are trying to minimise by participating in this structure.
This is the fundamental issue with poorly structured high cost, high leverage real estate development funding strategies; namely, as an Accounting 101 lecturer would say “there is a mismatch of project assets and liabilities”. A high cost interest-bearing capital structure (liability) and unknown project exit price and timing (asset) often puts a significant squeeze on the project development profit. We recently met with a developer who had paid +30% for preference equity and 12% for non-bank debt. For a project with a $1m pre-funding development profit, after funding they actually made $50,000 from the project. The interest cost accounted for ~95% of the profit to capital providers. The developer was lucky they made a profit at all. I am sure that the funder would argue that the risk profile of the project justified the high capital cost. I would argue that if this is the case, the capital structure probably wasn’t appropriate given the project fundamentals. To this point; project delay, cost blowouts and unforeseen events have a compounding effect (even more so if there is no or little equity buffer) as the interest clock keeps ticking. Clearly this is accentuated with a higher interest cost. One of the more common oversights that we see is underestimating the time required to exit a project after completion.
It is not our intention to deter stakeholders from investing in alternative capital structures. There are a lot of exciting opportunities in this space (for both investors and developers). We are very willing and active participants in alternative funding strategies both as an advisor and investor. However, transactions need to be structured appropriately (both in terms of risk and return allocation), properly thought out and with adequate due diligence and analysis undertaken. Often the fundamentals of a project simply do not suit an interest bearing capital structure. Some of the funding proposals that we see (like the one mentioned above) simply are not a sustainable (or equitable), responsible from an investment perspective or not suitable for the project in question. It is important to recognise that high cost, high leverage capital structures result in a skewed risk profile relative to more conventional project funding solutions. There is no one size fits all approach and what is “an appropriate amount of leverage” varies from project to project.
Adalia has significant transactional and structuring experience both in real estate and other industries. We are a real estate advisory and asset management business that works with property developers and investors to create bespoke funding solutions that create mutually rewarding project outcomes. You can learn more about Adalia and view our recent projects at https://adalia.com.au.