When More Debt Is Not the Answer: Funding a Development With a Capital Partner
Property developers are accustomed to solving funding problems with debt.
Senior construction finance is obtained first. If there is still a capital gap, mezzanine or second mortgage funding may be introduced.
But eventually a project reaches a point where adding more debt is either impossible or commercially unattractive.
The problem then changes.
It is no longer:
“Where can I borrow more money?”
It becomes:
“Where can I find the equity capital required to make this development proceed?”
That is where a property development joint venture or capital partner can become valuable.
What is a property development joint venture?
A property joint venture brings together parties with complementary resources.
Typically:
The developer contributes
the site, development opportunity, approvals, expertise and project execution.
The capital partner contributes
some or all of the equity capital required to complete the development.
The parties agree how:
- capital is contributed;
- decisions are made;
- risk is allocated;
- capital is repaid; and
- project profits are divided.
There is no single standard property joint venture structure.
Each arrangement should reflect the economics and risks of the particular development.
Why would an experienced developer give away part of the profit?
Because retaining 100% of a project that cannot proceed produces no development profit.
The more sophisticated question is:
What is the return on the developer’s scarce equity capital?
Assume a developer has $10 million in cash.
A conventional project requires all $10 million as developer equity and is forecast to generate $8 million in development profit.
The developer’s potential profit is $8 million.
Now assume an appropriate capital partner enables the developer to contribute only $5 million while retaining an agreed share of development profit.
The remaining $5 million can potentially support another project.
Even though the developer gives away some profit in each joint venture, the developer may produce a higher total return across two developments than by committing all available capital to one.
The value of a property development partner is therefore not simply the money contributed.
It is the additional development capacity created by releasing the developer’s own capital.
When is joint venture funding appropriate?
A property development joint venture may be worth considering where:
- the developer owns or controls a strong site but has insufficient cash equity;
- senior construction debt does not provide enough total funding;
- mezzanine debt would make the project’s debt burden excessive;
- a senior lender prohibits additional mortgage debt;
- the developer wants to preserve cash for another development;
- a distressed or time-sensitive acquisition requires substantial equity;
- a project needs recapitalisation during construction; or
- a developer can contribute expertise and opportunity but requires a financial partner.
The structure is particularly useful where the underlying development remains commercially strong but the developer’s capital position is the limiting factor.
Joint venture capital versus mezzanine finance
These structures solve similar funding gaps but operate very differently.
Mezzanine finance
Mezzanine is debt.
The lender normally receives:
- interest;
- establishment fees;
- agreed security; and
- repayment of principal.
The developer generally retains the remaining project profit.
Joint venture capital
JV capital participates economically in the project.
Depending on the structure, the capital provider may receive:
- repayment of contributed capital;
- a preferred return;
- interest on shareholder funding;
- a percentage of project profit; or
- some combination of these.
Joint venture capital can therefore cost more than conventional debt if the project is highly profitable.
But it can also carry materially greater risk than senior or mezzanine debt.
The decision should be made by comparing developer equity return, total capital cost, control and downside risk, not merely comparing headline rates.
Preferred equity can provide a middle ground
Not every development requires a full joint venture.
Preferred equity occupies the space between ordinary developer equity and traditional debt.
A preferred-equity provider contributes capital and receives priority economics ahead of the developer’s ordinary equity.
This can be useful where:
- the senior lender will not permit a second mortgage;
- the developer wants to retain more ownership than under a conventional JV;
- the project can support equity-style returns; and
- additional leverage would create an unacceptable debt burden.
The optimal structure may therefore involve:
senior construction debt + preferred equity, rather than senior debt + mezzanine or a full joint venture.
What does a capital partner look for?
Capital partners generally evaluate the developer and the project together.
A strong development site does not compensate indefinitely for a weak sponsor.
Likewise, an experienced developer cannot turn poor project economics into a good investment.
Important considerations include:
Developer track record
Has the developer successfully completed comparable projects?
Development margin
Is there enough genuine project profit to compensate both developer and capital provider?
Equity already committed
How much capital, site value and sunk expenditure has the developer already contributed?
Planning status
Is the project DA approved, construction ready or still subject to material planning risk?
Construction risk
Who is building the development? Is the contract fixed price? What contingency is available?
Valuation and GRV
Are projected sales supported by current independent market evidence?
Exit strategy
Will the project repay capital through presales, completed stock sales, refinance or another clearly identifiable exit?
Alignment
What happens if costs rise, completion is delayed or additional capital is required?
These issues should be agreed before the joint venture commences rather than negotiated after a problem arises.
Control matters almost as much as profit share
Developers commonly focus on the percentage of profit being surrendered.
That can be a mistake.
A joint venture agreement also determines:
- who controls the bank account;
- who approves major contracts;
- who controls sales pricing;
- whether budgets can be altered;
- who appoints consultants;
- what constitutes default;
- who funds cost overruns;
- what happens if further equity is required;
- whether either party can force a sale; and
- how disputes are resolved.
An apparently attractive 70/30 profit split can become commercially unattractive if the developer loses operational control over critical decisions.
The economics and governance should therefore be negotiated together.
How much equity can a joint venture provide?
There is no universal maximum.
Prudential Finance assesses joint venture opportunities individually and has access to structures capable of funding a substantial proportion of project costs.
For appropriate developments, current PRU joint venture structures can potentially provide total project funding approaching 95% of Total Development Costs, subject to project quality, developer experience, feasibility, security structure and capital-provider approval.
Prudential Finance considers projects from approximately $1 million to $500 million+, with joint venture structures particularly relevant to larger developments where the equity gap becomes material.
The most expensive equity is idle equity
Developers often concentrate on protecting percentage ownership.
But equity sitting in one development has an opportunity cost.
If introducing a capital partner allows the developer to:
- secure another site;
- commence another project;
- avoid a forced sale;
- refinance an existing capital partner;
- complete a delayed development; or
- preserve liquidity,
the economic benefit can outweigh the profit share surrendered.
The objective should not be to maximise the percentage of one development owned.
It should be to maximise risk-adjusted profit across the developer’s entire portfolio of opportunities.
What should a developer send Prudential Finance?
A useful initial joint venture submission should be concise.
Provide:
- property address;
- purchase price or current land value;
- development approval status;
- project description;
- total development cost;
- forecast GRV;
- existing senior debt;
- equity already contributed;
- additional capital required;
- project programme;
- builder details;
- developer track record; and
- current feasibility.
From this information, Prudential Finance can determine whether the appropriate solution is likely to be:
- senior debt;
- mezzanine;
- preferred equity;
- joint venture capital; or
- a combination of these.
Prudential Finance — finding the right position in the capital stack
The highest-cost mistake is often not choosing the wrong lender.
It is choosing the wrong type of capital.
A development with an equity problem cannot always be fixed with more debt.
Prudential Finance has more than 24 years’ experience in property development, debt and equity finance and access to private lenders, high-net-worth capital and other funding sources.
Where additional debt is not the optimal solution, we can assess whether a property development joint venture, preferred equity or another structured-capital solution can unlock the project.
To discuss a property development requiring equity or joint venture capital, contact Prudential Finance confidentially on 1300 550 669 or Hello@pru.com.au.
Recommended internal links:
Property Joint Ventures → primary money page
Preferred Equity → alternative equity solution
Mezzanine Finance → debt alternative
Construction Loans → senior debt
