The weighted average of the layers is two lines of arithmetic; what it tells you is how much of the project's income is spoken for before the common equity sees a dollar.
Multiply each layer's share of total cost by its rate and add them up. On an illustrative $100M development funded 65 per cent by a construction loan at 8 per cent, 10 per cent by mezzanine at 11 per cent, 5 per cent by preferred equity at 9 per cent and 20 per cent by common equity, the priority capital costs a blended 8.44 per cent, or 6.75 per cent of total cost, and the whole stack 9.75 per cent once the common equity is given a 15 per cent target.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The two numbers answer different questions. The cost of the priority capital, expressed on total cost, is the yield on cost the project needs before the common equity earns anything. The full weighted cost is the yield the project needs for everyone to be paid what they priced. A development memo should carry both, next to the yield on cost.
| Layer | Amount | Share | Rate | Annual cost |
|---|---|---|---|---|
| Construction loan | 65,000,000 | 65% | 8% | 5,200,000 |
| Mezzanine | 10,000,000 | 10% | 11% | 1,100,000 |
| Preferred equity | 5,000,000 | 5% | 9% | 450,000 |
| Priority capital | 80,000,000 | 80% | 8.44% | 6,750,000 |
| Common equity (target) | 20,000,000 | 20% | 15% | 3,000,000 |
| Whole stack | 100,000,000 | 100% | 9.75% | 9,750,000 |
The preferred equity sits with the priority capital: it is paid ahead of the common, its return is fixed and its upside capped, so in the stack it behaves like debt whatever it is called.
Blended cost = Σ (layer amount × layer rate) ÷ Σ layer amounts
Priority cost on total cost = Σ priority (amount × rate) ÷ total cost
In Excel, with amounts in B4:B6 and rates in D4:D6: =SUMPRODUCT(B4:B6,D4:D6)/SUM(B4:B6) for the priority layers, and the same over B4:B7 with the common target in D7 for the whole stack.
Suppose the project stabilises at an illustrative 7.5 per cent yield on cost, $7,500,000 of NOI. The priority layers take $6,750,000 of it, leaving $750,000 for $20,000,000 of common equity: a 3.75 per cent cash yield, a quarter of the 15 per cent target. The yield on cost clears the priority cost by 75 basis points and falls 225 short of the full weighted cost.
That is normal for development, and the reason is the exit. Valued at an illustrative 6.00 per cent cap, $7,500,000 of NOI is worth $125,000,000. Repay the $80,000,000 of priority capital and the common receives $45,000,000, a 2.25x multiple. The common equity's return in a development comes from the spread between the yield on cost and the exit cap, not from income, which is why yield on cost against the market cap rate is the first test and the blended cost of the stack the second.
| Stack | Priority share | Blended priority | Priority on total cost | Whole stack | Common cash yield |
|---|---|---|---|---|---|
| Senior 65% and common | 65% | 8.00% | 5.20% | 10.45% | 6.57% |
| Senior, mezzanine, common | 75% | 8.40% | 6.30% | 10.05% | 4.80% |
| Base: four layers | 80% | 8.44% | 6.75% | 9.75% | 3.75% |
| Senior stretched to 75% at 8.5% | 75% | 8.50% | 6.38% | 10.12% | 4.50% |
| Common target | 12% | 15% | 18% | 20% |
|---|---|---|---|---|
| Whole stack | 9.15% | 9.75% | 10.35% | 10.75% |
Each layer added between the senior loan and the common lowers the whole-stack figure and squeezes the common's cash yield, from 6.57 per cent with senior debt alone to 3.75 per cent with four layers. The common is being paid less income and asked to carry more risk, which brings up the mistake.
The first mistake is the unweighted average: (8 + 11 + 9 + 15) ÷ 4 = 10.75 per cent, a full point above the true 9.75, because it gives the 5 per cent pref layer the same weight as the 65 per cent senior loan. The second is subtler. Holding the common target at 15 per cent while adding mezzanine and pref makes the stack look cheaper, 9.75 against 10.45 per cent, but a thinner common slice is a riskier one. To keep the whole stack at 10.45 per cent, the common in the four-layer stack would need 18.50 per cent, the kind of premium a thinner, more junior slice can reasonably ask for. Junior capital moves risk to the common; it does not remove cost. Which of the two junior layers is cheaper for the sponsor is worked in mezzanine against preferred equity.
Weight by amount, not by layer: here the priority capital costs 8.44 per cent, or 6.75 per cent of total cost, and the whole stack 9.75 per cent. Set the first against the yield on cost to see how much income the common keeps, and treat any fall in the second from adding junior layers with suspicion. The free workbook for this case carries the stack, its blended cost and what each layer recovers across a range of exit values.
At least the cost of the priority layers expressed on total cost, and the full weighted cost to pay the common equity its target. On the illustrative 65/10/5/20 stack the priority layers cost $6,750,000 a year, 6.75 per cent of the $100M cost, and the full weighted cost is 9.75 per cent. A 7.5 per cent yield on cost covers the priority layers but leaves the common only a 3.75 per cent cash yield.
For the blended cost of the stack, treat it as priority capital with a fixed return, because it is paid before the common equity and its upside is capped. On the illustrative stack, 5 per cent of cost at a 9 per cent pref adds $450,000 a year and takes the priority capital to 80 per cent of cost at a blended 8.44 per cent.
Only on paper. Holding the common equity at 15 per cent, moving from senior and common to the full four-layer stack takes the weighted cost from 10.45 to 9.75 per cent. But thinner common equity is riskier; to keep the weighted cost at 10.45 per cent the common would need 18.50 per cent, the kind of premium a thinner, riskier slice can reasonably ask for.
This article is one calculation from Private Equity Real Estate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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