The Power of a Funding Stack: How Investors Are Maximizing Property Investment Returns
When it comes to investing, having flexible ways to fund new opportunities is key to success. If we specifically consider property investment, one particular strategy that investors are snapping up is by endorsing the use of a funding stack.
A funding stack – also known as the capital stack – is a financial structure that describes the layers of funding used to finance investments, and most commonly; property development.
Consider a funding stack like a layered cake. Each layer represents a unique funding source, individually contributing to a specific role, priority and level of risk. The purpose of a funding stack is to help investors and developers make the most of their capital, whilst also reducing financial commitments by diversifying risk.
Funding stacks can be complex, so understanding the intricacies of these structures is crucial for investors. In this article, Marc Champ, Managing Director at Wharf Financial, describes the different lending options available in the funding stack, and the advantages and disadvantages worth considering.
Funding Stack: Equity and Debt
Before diving into the pros and cons, it’s important to understand how a funding stack works.
A typical stack has three layers; senior debt, mezzanine debt and equity, with equity at the top of the stack, followed by debt solutions. As investors looking to deploy capital, how you approach the hierarchy of funding will depend upon its structure and your potential risk vs ROI.
By way of example, investors looking to lend may provide funding (the debt) to a developer looking to refurbish a derelict property. The developer will front the initial equity before looking for investment to fund the rest of the project. Once the project is complete, the developer will most likely refinance or sell the property for an increased value before repaying the investment capital and returns.
Following an assessment of the opportunity, investors can decide how risky the investment is. If a low loan-to-value (LTV) loan is required (for example £100,000 against £1,000,000 i.e 10%) the opportunity is deemed fairly low risk. However if it is more risky, for example an 85% LTV investment, the developer can either be encouraged to increase their equity – subsequently reducing the investors loan amount – or investors can reduce exposure by bringing in other investors on an second charge or mezzanine debt basis.
Equity investment is always at the top of the stack, followed by mezzanine or second charge finance if required, then senior debt lending at the bottom. Debts are repaid from the bottom up.
Types of Finance In The Property Funding Stack
Equity Investment
In property development, equity is often provided by the developer(s) and forms the most flexible part of the funding stack. Typically, equity is raised via the developer’s own funds or by attracting joint venture partners. It does not incur interest costs, but it does reduce the overall ownership stake, sharing both the risks and returns of the investment.
Senior Debt
Senior debt loans typically make up the largest portion of the funding stack and use the property itself as security. That’s why it gives investors priority in claiming the property if the borrower defaults. This type of debt is considered the most cost-effective option due to its low-risk nature; making it attractive for investors looking to explore buy-to-let, development or commercial property.
Types of senior debt finance include:
Mezzanine Finance
Mezzanine finance is a hybrid finance solution, often used to plug the gap between the senior debt and equity. It holds a riskier position, therefore carries higher interest rates but enables equity investors to access more capital with limited upfront funds.
For development projects where additional capital is needed beyond what a senior loan provides, mezzanine finance is a popular solution.
Second Charge Loans
A second charge loan is another type of finance that sits behind the first charge. This type of loan can be effective for short-term needs or value-add projects, but as they’re subordinated to senior debt, have higher interest rates and carry more risk.
By combining these types of investment loans, property developers and investors can create an optimised funding stack by balancing cost, flexibility, risk and projected ROI.
Risk Considerations of A Funding Stack
A funding stack is an essential tool for investors looking to diversify funds and maximize returns when investing in property. However, while the funding stack can enhance financial flexibility and reduce personal capital outlay, it also comes with distinct risks that investors should understand and manage carefully. Here are four considerations for investors to consider.
1. Priority and Security Risks for Second Charge and Mezzanine Funders
In a funding stack where debts are prioritised by seniority, senior debt investors hold the most important position as these funders will be repaid first if defaulting occurs. The other forms of debt, like mezzanine finance and second charge loans, come after senior debt in terms of repayment priority. As such, these types of debts bear risk for the funders, that’s why they come with higher interest rates attached to them.
2. Economic Volatility & Market Risks
For investors deploying debt finance, economic volatility and market changes may cause the borrower to suffer from cash flow management issues. Should this occur, borrower’s may struggle to meet repayment obligations, subsequently impacting the investment and potential returns.
3. Over-Leveraging & Negative Equity
One of the biggest concerns of using a layered funding stack is over-leveraging. While leveraging different types of debt can enable a borrower to control a larger asset base with less personal capital, it also increases exposure to negative equity.
This presents a significant issue for investors. If we were to face a market downturn whereby property values decline, an over-leveraged property stack could increase the borrower’s vulnerability to negative equity, subsequently jeopardising investor funds. If the property is worth less than the outstanding debt, it may become more difficult to sell or refinance.
4. Reduced Control and Authority Dilution
By becoming a debt investor, all partners usually agree to split profits and this can result in dilution of returns. Furthermore, investors may not have a say in decision making which potentially limits authority over the project. Such situations may lead to conflict if there are differences in project strategies or financial objectives. Investment arrangements may also incorporate terms that give precedence to preferred equity payouts, therefore influencing the profits available to other parties involved.
Managing Property Funding Stacks
For individuals considering investment in property, it is typically considered a robust investment and can be highly lucrative if successful. By diversifying funds across different projects with multiple funding stacks, investors have found this to be a popular way of leveraging multiple funding sources to maximize returns.
To reduce the chances of encountering challenges, investors should not only be aware of the possible risks, but also perform thorough research on the borrower, property, security and project by carrying out sensitive due diligence and practical cash flow estimates.
Collaborating with expert property finance advisers who can assist in developing a strong financing strategy is also key to success. By collaborating with market experts, the immediate financial need can be identified with future investment objectives carefully considered, ensuring viable investment plans are created for success.
Keen to get involved in property investment or development? Wharf Financial has a team of expert advisers ready to source finance solutions for clients. To find out how to get started, contact us today.
