The Equity option provides a straightforward means of assessing the effect on development value and investor return in the event that the proposed development is not entirely funded from one source.
There are many different ways of applying equity to development projects therefore the levels and methods used differ from development to development. It is a difficult subject to standardise. What has been provided in Prodev is a simple equity / debt model based on the developer providing a level of equity and the bank putting in the remainder.
To apply Equity in the Timing Screen, highlight the Contributed Equity item and enter either a percentage (of total cost before interest) or an amount followed by the Enter key. This represents the Developer’s contribution not the Bank’s.
Generally speaking a bank will lend up to 70% of development value so the developer or another source must come up with the remaining 30%. The primary lender (i.e. the bank) will only ever receive interest as its return on the loan but they will be covered to the extent that they have a first charge over the property despite not having supplied all the finance against it. The developer or equity holder has to provide the remaining finance and whilst this is much riskier than the bank’s position, it does have the advantage that any profit accruing from the development will also revert to the equity holder giving a much higher level of return than if the project was 100% financed.
The purpose of the Equity provision within Prodev is to assess the level of return that the equity provider will receive and the effect of the reduced interest charges on the development.
For example if a project costing £1 million makes a profit of £200,000 then this represents a profit on cost of 20%. If the developer puts up 30% of the cost then the £200,000 profit will result from the developer's contribution of £300,000 (rather than the full £1 million) giving an equity yield of 66.67%.
Equity method
There are two methods by which the developer's equity contribution is paid into and received back from the overall development. These are 'Side by Side' and 'Lender Priority'. Please note that the method chosen is set using the Profit-Type menu on the Data List and not within the Time/Finance section.
Side by Side
The Side by Side method assumes that the principal lender (bank) and equity provider (developer) simultaneously provide their share of the finance whenever it is required. For instance if the developer is providing 30% equity and the total development cost in any particular month is £100,000 then the bank will provide £70,000 and the equity provider will put up the remaining £30,000. In the final period of the project the bank will be paid off and the equity provider (developer) will receive the balance of the development surplus, part of which will constitute the repayment of the equity provided.
Lender Priority
The Lender Priority method assumes that the equity provider (developer) is 'junior' to the principal lender’s (bank's) position in that the equity must be fully paid in to the scheme before any of the bank's contribution is provided. At the end of the project this process reverses in that the bank must be fully paid off before any equity can be repaid or profit taken.
When a payment is made, the cashflow will first look to see if there is any equity available to meet this debt and will use this in place of the loan until such time as the equity is used up. As the first payment made in a development is normally the Site Value this will generally use up all equity available, however if the equity is not used up in the first period then the remaining balance will roll forward a month at a time until it is used up, at which time the loan will come into play.
The debt, being 'senior' to the equity, will have to be repaid in full before any equity can be repaid to the developer, however should this take place before the end of the development program then any surplus funds will be used to repay the equity. Finally, in the last period of the project the surplus arising from the development will revert to the equity provider, part of which will constitute the repayment of the equity provided.
How Equity is applied in the Cashflow
When Equity is applied, an extra cashflow line (named Equity) will be included in the Print Preview cashflow report, towards the bottom of the page where the actual calculation takes place. This shows the equity contribution. As it offsets cost it will show as positive when paid into the project and negative when paid back to the equity provider.
Return on Equity
As well as reducing interest costs the flow of equity (the developer’s contribution) can be measured in terms of financial performance. The developer is contributing money initially then receiving that money back over time along with the surplus (profit). The two methods are set using the ‘Show Equity as’ dropdown.
Profit on Equity
This is a simple calculation showing the profit as a percentage of equity provided. It is a straightforward indicator but does not adequately take into account the timescale of the development, and is similar to the Profit on Cost statistic used for the development as a whole. In the appraisal report this is referred to as ‘RoE as Profit’.
IRR on Equity
This considers the complete flow of Equity Finance during the course of the development as an annual IRR. If this option is selected you should view the cashflow (in Print/Preview mode) as one of the bottom lines will show the Equity provider's flow of funds (Equity Balance), which is used to calculate the IRR on Equity. In the appraisal report this is referred to as ‘RoE as IRR’.
Interest on Equity
There is no interest calculation applied to the flow of equity (unlike the debt). Any interest considerations are implicit within the Return on Equity which in normal circumstances should be in excess of the cost of borrowing. This is best demonstrated using the ‘IRR on Equity’ setting.