Sometimes cheap bank debt is not actually so cheap. Sometimes non-bank finance that seems to be a great alternative can kill a project.
At STAC we’ve written before about non-bank finance being a great alternative, but then we’ve negotiated plenty of bank development finance deals.
So which one is actually best for you and your project?
The thing is, there is no simple answer and it often requires financial modelling, combined with thoughtful consideration of a number of factors, including the fine-detail T&Cs.
The fine detail of T’s & C’s is a story for another day; today the question is about that cheap interest rate, or vice-versa, and the need to look into the finance cost more deeply – particularly when you have multiple layers in your capital stack.
What is WACC and Why is it Important?
One of the most common responses about Mezzanine Debt or Preferential Equity is “holy s#!% that’s expensive money!”; but often the ability to clearly see the forest is simply a case of gaining perspective through looking at the WACC.
WACC: Weighted Average Cost of Capital (i.e. what rate you’re paying for ALL of your money, rather than looking at each source/tranche in isolation)
In really simple terms, if you borrowed $5m at 5%, and another $5m at 15%, rather than getting hung up on how expensive that second piece is, consider that your WACC is 10%; AND, if you need the whole $10m, the question is then whether 10% is an acceptable cost of funds for your project.
Maths not your strong point?
Here’s a 30 second lesson on how to do a basic WACC calculation:
- Calculate what percentage of the total debt each loan amount is (e.g. if Loan #1 is $5m, of a total of $7.7m in debts, then $5m divided by $7.7m = 65%)
- Multiply the percentage result from step 1, by the loan’s cost of capital (e.g. if Loan #1 costs 5%, then 65% x 5% = 3.2%)
- Add together each of the results of step 2 for each of the loans, to give you your WACC (here’s an example below)
| Loan (a) | % of total (b) | Loan’s rate (c) | (b)x(c) | |
| $5,000,000 | 65% ($5 / $7.7) | 5% | 3.2% | |
| $1,200,000 | 15% ($1.2 / $7.7) | 15% | 2.3% | + |
| $1,500,000 | 19% ($1.5 / $7.7) | 25% | 4.9% | + |
| $7,700,000 | Sum = 10.5% | = WACC |
Ok so Development Margin – WACC = Profit Margin? NO!
This is often the equation that people jump to in their minds – “the project has a 20% profit margin, so if my capital costs me 12% then I’m only making 8%!!”.
No.
Time is Money
Time is the big variable that is often overlooked when considering the cost of property development finance.
Single stage Land Subdivisions often only need debt for 6 to 8 months, so a high WACC won’t actually cost that much in $ terms, for example:
- $10m Total Development Cost (“TDC”) and a 20% Return on Cost (“RoC”) = $2m profit.
- If you borrowed the whole $10m and your WACC went up by 5%, and you had the money for 7 months, then reduction in Profit = $10m x 5% / 12 x 7mths = $291k
- = new RoC 17%
But with a high-rise tower, you might need the money for over 2 years, so a high WACC could cost you a massive amount in $ terms. Using the above numbers of $10m borrowed and a 5% higher WACC / 12 x 24mths = $1.0m reduction in profit = new RoC 10% (halved!!).
Although the above examples are far more rudimentary than we would ever use to compare actual project financing options, they prove the “time is money” point, that the same increase in WACC only marginally reduced the RoC in one case, but halved it in the other.
Critical factors to properly assess Finance Cost impact on Project Viability
Realistic Project Timeframes
- Lead-in time is critical. If you’re paying investors 20% from day 1, but it’s going to take you 12 months to meet the bank’s Conditions Precedent so that you can start construction, that cost of that time must be considered in assessing all of your options.
- Construction including delays. Even if the builder tells you they can build in 6 months, that doesn’t mean your total construction period will be that quick. Delays happen on the vast majority of projects, for myriad reasons, weather being just one.
- Settlements are rarely quick either. Practical Completion of settlements takes far longer than a few weeks, it’s rare to happen any quicker than 2 to 3 months. Between all of the paperwork that needs to happen between contractors, certifiers and Councils & Government agencies, combined with the process of buyers getting their loan approvals, delays very easily occur here. This is a particularly expensive delay for developers, as you’re at “peak debt”, so your interest bill clocks up rapidly as each day goes by (e.g. a $10m loan with a 10% WACC runs up nearly $3,000 every single day in interest).
Debt Pricing Structure
- “All Up” numbers on Senior Debt mean NOTHING. A common reference to pricing, both by borrowers and lenders, is “all up” price – e.g. if the interest rate is 4% and the line fee is 3%, then the loan is “7% all up”… But if I change that to 6% rate + 1% line fee and model a typical project, the former can be more than 30% more expensive.
- Consider other “not so obvious” fees. Beyond the usual Establishment/Application Fee, there is a tendency for other fees to be included that aren’t so obvious, particularly in the non-bank space. For example:
- Management or Administration Fees, which can be quoted as either a % or as a $ amount. You might say you have an “all up” rate (which of course we’re telling you to not say!!) of 10% on $10m, but if there’s a management fee of $8,500 per month, then bump that up another 1%.
- Extension Fees, which can be particularly hefty; often caused by getting a long enough loan term at the beginning. We’ve seen some developers get stung 6-figure sums for only a few days’ extension. Seriously. So some early realistic planning, consideration of reasonable potential delays, and negotiation with the lender is what is needed here.
Model it and focus on the Bottom Line
Assuming you don’t have a PhD in Mathematics, there is really only one simple way to work out the right answers here – and that is to use a proper financial model built specifically for property development – whether that be excel-based or specific software.
Or of course, you could engage a professional Debt Advisory firm like STAC to work through all of the project factors with you, analyse the various capital structuring options that may be available to you, then provide logical analysis-based recommendations to you as to the most suitable outcomes for your project.
If any of this has you wondering about what the true cost of your capital package is for your project, or that of a client’s, we’re always open to an obligation-free discussion.
Also, if you have any questions about the specifics, pros & cons of Mezzanine debt, Preferential Equity and Joint Ventures, have a read of a previous blog of ours on this topic by clicking here:
