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This article has been written by Saam Lowni, Merryoaks Managing Director.
Some developers will not like this but having seen so many car crash endings to these situations, I think it’s worth mentioning.
The problem I see is when developers use debt as equity. To be clear, I am not saying “do not do this”. I can understand the attraction for a developer as they are tempted with only giving away ~10% over the 20%+ that equity would command, and it is typically easier to raise. But it’s important that both developer and investor understand the risks of building the capital stack in this way.
With debt totalling 100% LTC this leaves very little margin for error. Typically, the only time this really works well is when everything goes perfectly to plan in terms of the delivery and exit of the project (which almost never happens) and/or the project is delivered during a rising market.
More likely, the build cost goes up, the sales period takes longer than anticipated and the GDV might fall to ensure the units are sold as quickly as possible. All of this leads to a skinny margin and all too often, instances with no margin at all which means a loss.
And as the capital stack was built with 100% debt, the developer cannot walk away and on to the next project.
They either have to find a way to pay back the investors, file for bankruptcy, or they have to borrow more money to repay the losses in the hope of future profits to make up the difference. This is the start of the vicious cycle which manifests in an unplanned Ponzi scheme over the long term.
The common correlation I have found is the more popular and higher profile the developer, the easier it is to raise cash and the longer these cycles run, the bigger the holes/losses by the time the music stops.
The developer can raise more capital (as debt which is repayable win, lose or draw) which becomes a ticking time bomb. So, they rush to acquire a new site which results in projects being bought at a price likely too expensive. Then the series of inevitable doom continues until the developer runs out of people to raise cash.
So, if you are a developer with this approach, be extra careful with the deals you do, the capital stacks you build and at the very least try to guess correctly whether the market is in an upward or downward trajectory.
If you are an investor, always ask for a balance sheet from the developer and do your own due diligence to ensure the figures on both the assets and liabilities sections are accurate, or really, get comfortable with taking an equity position and ask for a higher return.
To learn more about how to use the Capital Stack effectively, read our blog post here. For help structuring the finance for your deals, speak to our Funding Specialists today.
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