1. CALCULATING THE VALUE OF PREFERENTIAL
EQUITY FUNDING TO A PROJECT’S PROFITABILITY
— Property Finance Partners
The Key to Calculating the Value of Preferential Equity Funding is in considering the
following Key Performance Indicators:
1. The Weighted Average Cost of Capital (WACC) of the Bank Debt and Preferential Equity funding; and
2. How much less of your own Equity you need to put into the project as a result of the Preferential Equity funding;
3. What the net effect to your Return on Equity (“RoE”) is.
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 Preferential Equity funding either to complete larger projects or more
projects than they would otherwise be able to.
While higher gearing does present higher risk on a single project Preferential Equity funding when used
appropriately to spread your equity across multiple property developments can actually decrease portfolio risk
by increasing diversification.
Well planned Preferential Equity funding produces an increased return to the developer and allows them to preserve
equity for other deals, building their pipeline.
Spread your capital over more projects and take full advantage of the strong market
conditions. To obtain a Development Feasibility to see how to maximise your RoE
while at the same time minimising the amount of capital deployed contact Fergus
McMahon at Property Finance Partners Ltd.
fergus@propertyfinancepartners.co.nz 022 390 7963
Step 1. Calculate the Weighted Average Cost of Capital (WACC):
Using the % of equity multiplied by the cost of capital, add the % of debt used multiplied by the after tax cost of debt.
Step 2. Calculate the Level of Developer Equity Reduction:
If the bank will fund 80% of Total Project Costs (TPC), you would need to put in 20%. However if you use Preferential
Equity funding 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.
The effect on your Return on Equity is profound in terms of profitability. This is why professional property developers
prefer to use the minimum amount of capital required.
Your Property Development Bank Debt Only Bank + Pref Eq Funding
TPC – Total Project Cost $10,000,000 $10,000,000
Bank Debt at 80% of TPC $8,000,000 $8,000,000
Preferential Equity at 10% of TPC nil $1,000,000
Equity Required $2,000,000 $1,000,000
Dev Margin at 20% of TPC $2,000,000 $2,000,000
Cost of Pref Eq at 25% nil $250,000
Net Project Profit $2,000,000 $1,750,000
Return on Equity 100% 175%
www.propertyfinancepartners.co.nz
Step 3. Calculate the Effect on the
Project’s Return on Equity:
Because the cost of Preferential Equity
funding 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 your Return on Equity is
materially substantial – see this typical
example to the right: