Development Funding – What are the real property development costs involved?

Development Funding – What are the real property development costs involved?

When looking at property development costs, the two most common questions from property developers are:

  1. “What is the “all up” rate of the bank’s facility?” – i.e. BBSY (Bank Bill Rate) plus Margin plus Line Fee; and
  2. “How high is the rate for Mezzanine Debt?”

What many do not realise is that the common answers to these questions are generally not the correct ones.

Real Property Development Cost #1: The “All Up” Rate

The “all up” rate of a bank’s facility is more than you think. When it comes to bank finance, the key here is the line fee, which is charged on the facility limit, not the loan balance.

As the loan progressively increases in balance each month with development finance, the average balance over the life of the facility is typically about 60% of the facility limit.

So, if Line Fee is 1.5%, then the true cash flowed rate is 1.5%/60% = 2.5%.

Because of this amplifying effect which many developers overlook, consider these “equivalent” all up rates:

BBSY Margin Line Fee “All Up” True Line Fee rate Real “All Up”
2.15% 2.50% 0.50% 5.15% 0.83% 5.48%
2.15% 1.50% 1.50% 5.15% 2.50% 6.15%
2.15% 0.50% 2.50% 5.15% 4.17% 6.82%

With the same “all up” rates, there is a variance of 1.34%.

This oversight of true cost also applies to mezzanine property finance where financiers often quote rates anywhere from 12% to 25%. Again, the true cost can be found in the fees – however, given mezzanine finance is generally fully-drawn from day 1, the true cost is calculated differently. Consider these examples over say a 12-month term:

Interest Rate Establishment Fee Exit Fee Exit charged on “All Up” True All Up
12.0% 5.0% 1.5% GRV 18.5% 32.1%
20.0% 5.0% 1.0% Mezz Limit 26.0% 27.5%
24.0% 3.0% 0.0% N/A 27.0% 28.0%

Note that with the lowest rate, I’ve used a common example of an Exit Fee being charged on the Gross Realisation Value (GRV) of the project, instead on the mezzanine facility’s limit – which can be a massive effect given mezzanine debt is often only up to 10% of GRV.

Clearly, when comparing finance costs from different lenders, it is vital to truly compare apples with apples.

Real Property Development Cost #2: WACC –  Why mezzanine funding is cheaper than you think.

In instances that a project or company has more than one cost of finance, e.g. where a Senior Debt and mezzanine finance for property development are used, Weighted Average Cost of Capital (“WACC”) is essentially the calculation of the overall cost of all sources of finance combined.

As bank funding is currently so cheap, combined with the fact that mezzanine debt is typically a relatively small percentage of the total debt, the WACC of bank plus mezzanine debt is actually very low.

As an example, if senior debt is 65% and mezzanine debt is 10% of the project’s GRV, with the true “all up” cost being say 6% and 25% respectively, then the WACC would only be:

((65% / 75%) x 6%) + ((10% / 75%) x 25%)

= 5.20% + 3.33%

= 8.53% WACC

So, what seems expensive on the surface, is actually lower than what bank rates for development loans were only a few short years ago.

Calculating the real property development cost of mezzanine debt

The key to calculating the real property development cost of mezzanine debt is in considering:

  1. The WACC of the senior and mezzanine debts;
  2. How much less Equity you need to put into the project as a result of the mezzanine debt; and
  3. What the net effect to your Return on Equity (“RoE”) is.

1. Calculate the WACC

Lets use the above example of 8.53%.

2. Equity reduction

If the bank will fund 80% of Total Development Costs, you would need to put in 20%.

If, however, you use mezzanine debt of say 10%, you would only need to put in 10%. Therefore, the required equity is half of what it would be solely with bank debt.

3. Effect on RoE

Because the cost of mezzanine debt increases your WACC, your net project profit will naturally be lower than if you only used bank debt. However, given the WACC is only marginally higher than the bank’s rate, the effect on RoE is profound.See this typical example calculation:

 Bank Only  Bank + Mezz
TDC  $10,000,000  $10,000,000
Bank debt @ 80% TDC  $8,000,000  $8,000,000
Mezz debt @ 10% TDC  $-  $1,000,000
(a) Equity Required  $2,000,000  $1,000,000
Dev Margin, 20% of TDC  $2,000,000  $2,000,000
Cost of Mezz at say 25% all up, 12mths  $-  $280,732
(b) Net Project Profit  $2,000,000  $1,719,268
Return on Equity ( b / a ) 100% 172%

The low WACC, combined with resulting significantly higher RoE, is a key reason why many of the country’s leading developers are currently taking advantage of mezzanine debt or preferential equity, either to complete larger or more projects than they would otherwise be able to.

Whilst higher gearing does present higher risk on a single project, when used appropriately to spread your equity across various projects or investments, it can decrease portfolio risk by increasing diversification.

In this article we’ve covered two key questions about property development costs. They were:

  1. “What is the “all up” rate of the bank’s facility?” – i.e. BBSY (Bank Bill Rate) plus Margin plus Line Fee; and
  2. “How high is the rate for mezzanine debt?”

In answering these questions about the real cost of property development, we hope we’ve given you a greater understanding of how you can leverage these debt finance strategies to successfully launch your new development project.

Development Finance Partners is an advisory firm with a strong track record in writing mezzanine finance and preferential equity facilities on property development projects, combining pragmatic and thorough risk analysis of projects and portfolios to support their clients’ growth strategies whilst managing their risks. Discover our mezzanine finance and preferred equity services.

DF Partners want to make your next project a success.

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