Basic Debt and Equity Structure

In a typical development project, debt will fund from 50 to 80 percent of project costs or value, with equity paying for the remainder. Some developers and investors prefer debt to remain below this range, while others look for higher levels - in some cases achieving 100 percent debt financing when conditions are right.

Debt for a development project occurs in two stages:

1. Construction Loans - Part of a category of loans called “acquisition, development, and construction loans, or ADC - are short-term; they are usually adjustable rate loans tied to the Prime or SOFR rate and often require developer guarantees that are secured by recourse to the developer’s assets. Although acquisition and development are two purposes for which these types of loans are made, their most frequent use is for construction. Most construction loans are provided by banks and are based on a percentage of project costs. Not all project costs are eligible for inclusion, however; usually, only on-site costs associated with the primary collateral for the loan are eligible, off-site costs, such as traffic signal, generally are not.

2. A permanent loan repays the outstanding construction loan based on the lender’s underwriting criteria for adequate debt overage and/or the LTV percentage. Permanent loans are generally nonrecourse, so the lender looks only to the property value as security for the loan. These loans may have a fixed or adjustable rate, may be interest only, or may even involve negative amortization they typically have a required payoff, usually within five to ten years, and a longer amortization, usually 30 years. This structure creates term risk—when the developer may not be able to arrange an appropriate new loan sufficient to repay the old loan and to provide a return of excess financing proceeds to equity investors.

After a project is built, if it is a for-sale project, the debt and equity capital used for building is repaid from sales proceeds, with debt repaid first and equity investors receiving a distribution of the remaining sales proceeds. For an income-producing project, the permanent loan replaces the construction loan and is usually repaid in monthly installments. Equity investors receive their return from the revenues that are available after paying these installments and operating costs.

As a rule, the equity portion of funding for a development project pays its share of the project costs first, before the construction loan starts funding. This ensures, right from the start, that the lender is insulated from risk exposure by the equity investor. It also ensures at the outset that the lender does not fund the project to a higher share of project value than the lending criteria allow.

After the project is completed and either sales are completed or the permanent loan is in place, the project profit after debt service and operating expenses is distributed in a waterfall. The first pool pays the equity investors a high percentage of profit, first, to repay principal (return of equity) and, then, to pay a “preferred” annual return on equity—typically 8-12% depending on market conditions and project risk profile. After the requirements of return of equity and preferred return have been met, subsequent distributions pay a “promotional” return to meet the investors’ target return rates. After those targets are met, the percentage distribution between the developer and equity investors shifts to give a higher percentage distribution to the developer.

Usually, the developer is required to “co-invest” with the equity investors. This co-investment, which ranges from 5 to 15 percent of the equity amount, ensures that the interests of the developer and equity investors are aligned. The developer receives a return on this amount when the equity investors do, separately from the developer return that is paid in the waterfall distribution of profits. Developers may also be paid fees apart from returns; these fees become part of the overall development costs.

Some projects that have existing debt and equity are financed with an intermediate category of capital that adds to the capital stack; it is called, variously, “performing debt,” “gap financing,” “subordinated debt,” “junior debt,” or “mezzanine debt.” This financing funds a gap that neither the primary debt nor equity covers. It typically finances a component of project costs associated with a change in future project value that results from a fundamental conversion of the project. For instance, mezzanine debt might finance a major renovation and retenanting of a shopping mall.

Mezzanine debt can be structured purely as “junior debt” that increases leverage and receives only an interest rate return to the lender. As leverage resulting from mezzanine debt increases, it receives both an interest rate return and a return based on project performance. So mezzanine debt combines features of debt and equity. The mezzanine lender may also secure its loan by becoming a participant in the joint ventures that owns and controls the project or require an “inter-creditor” agreement to make the loan that provides some access to the property value in the event of foreclosure. Some mezzanine loans are also secured by the project owner’s assets.

Returns to mezzanine debt can vary widely depending on the degree of leverage and the degree of risk assumed by these investors. Because mezzanine debt’s priority of payment is lower than that of the primary debt, mezzanine investors expect rates of return somewhere between those of debt and equity. Those rates may vary from 8 to 20 percent or greater, depending on the risk investors assume.

The amount of debt that a project qualifies for varies with its financial viability, the strength of the developer, and the conditions in the capital markets.