Understanding the Capital Stack

What is the Capital Stack?

The capital stack describes how a property development is funded — the layers of capital that combine to cover the total project cost. Understanding the capital stack is essential for any property developer because it directly affects your cost of finance, return on equity, and overall project profitability.

In its simplest form, a development is funded by debt (a loan) and equity (your own money). But in practice, the capital stack can include multiple layers of debt and equity, each with different costs, terms, and risk profiles.

The Layers of the Capital Stack

Senior Debt sits at the bottom of the capital stack and carries the lowest risk (and therefore the lowest cost). The senior lender takes a first charge over the property and is repaid first from any proceeds. Senior debt typically provides 55-70% of total costs at rates from 0.65% per month.

Mezzanine Debt sits above senior debt and carries more risk. The mezzanine lender takes a second charge and is repaid after the senior lender. Mezzanine typically provides an additional 15-25% of total costs at rates of 1.0-2.0% per month.

Equity sits at the top of the capital stack and carries the highest risk. Equity investors are repaid last — after all debt has been repaid. In return for this risk, equity investors receive a share of the development profit rather than a fixed interest rate.

Developer Equity is your own contribution to the scheme. This is genuinely at risk — if the project fails, you lose your equity before anyone else loses money.

Worked Example: A Typical Islington Scheme

Consider a conversion project in Angel with total costs of £2,000,000 and a GDV of £3,200,000.

Scenario 1 (Senior Only): Senior debt at 65% LTC provides £1,300,000. Developer equity required: £700,000 (35%). Interest cost at 0.70% pm over 14 months: approximately £83,000. Developer profit: approximately £1,117,000. Return on equity: 160%.

Scenario 2 (Senior + Mezzanine): Senior at 65% LTC provides £1,300,000. Mezzanine at 20% provides £400,000. Developer equity: £300,000 (15%). Blended interest cost: approximately £120,000. Developer profit: approximately £1,080,000. Return on equity: 360%.

Scenario 3 (Senior + Mezzanine + Equity Partner): Senior at 65% provides £1,300,000. Mezzanine at 20% provides £400,000. Equity partner provides £200,000. Developer equity: £100,000 (5%). Profit share to equity partner (40% of profit): approximately £430,000. Developer profit: approximately £530,000. Return on developer equity: 530%.

This illustrates the fundamental trade-off: higher leverage increases return on equity but reduces absolute profit and increases risk.

Optimising Your Capital Stack

The right capital stack depends on your specific circumstances and objectives. If you want to maximise absolute profit and have sufficient equity, a senior-only structure minimises your cost of capital. If you want to maximise return on equity or run multiple projects simultaneously, adding mezzanine or equity reduces your capital requirement per scheme.

The key constraint is project profitability. Your development must generate sufficient margin to cover the blended cost of all capital layers and still deliver an acceptable return. As a rule of thumb, lenders want to see a minimum 20% profit on cost — and higher for schemes with more leverage.

We help Islington developers structure the optimal capital stack for each project, balancing leverage, cost of capital, and risk appetite.