Real estate development has traditionally been limited to those with the deepest pockets. However, today, anyone with the right financing can break into the industry. Someone without deep pockets or political connections can develop successful real estate projects. The challenge lies in understanding the different financing options available, how they differ, and how they can be used.
What Financing Is Needed?
Real estate development is costly. There’s the initial purchase price of the property, whether that’s an existing structure or undeveloped land. Developers will also need to purchase permits and licenses, pay for surveys and studies, and a great deal more, and all of this is before groundbreaking occurs for construction. And the larger the development, the more in-depth the surveys and studies will be. Different geographic areas will also entail additional steps. For instance, a development in central Alabama will have very different environmental and ecological requirements than one on the Pacific Coast in California.
Finally, the development process will require funding – materials, manpower, and everything else required to bring the developer’s vision to life must be purchased. All of this requires financing, but each type has unique pros and cons that may make it better or worse for specific projects.
The development process includes four broadly defined phases. These are site selection and land acquisition, pre-development and land entitlement, development and construction, and post-construction and operation. Each phase has its capital requirements and is usually funded by different types of financing depending on the level of risk.
Understanding Real Estate Development Financing
To achieve success in real estate development, it’s critical to understand the various financing options available. The choices available include crowdfunding, equity financing, debt financing, syndicated debt, and conventional loans.
Often, developers will need to harness more than one type of financing. For instance, the capital stack (a term that refers to the layers of financing within a real estate development project) usually includes both debt and equity financing.
Crowdfunding for Real Estate Development
Crowdfunding for real estate development is a newer option and is made possible by digital technology. It has revolutionized real estate development in many ways and made it possible for the “little guy” to get involved in an industry traditionally reserved for those with wealth, position, or both.
Thanks to the Jobs Act of 2012 (which was implemented in 2016), real estate developers are now able to solicit investors who may have no preexisting relationship with them. Moreover, they’re able to use new platforms to make those connections, such as social media. Investors with less capital are also able to invest in projects that once required only accredited investors (those who were already quite wealthy).
In short, crowdfunding allows the democratization of real estate development. Developers can now invite the general population to make direct investments in their projects and make challenging projects more feasible.
Equity Financing for Real Estate
Equity financing makes up a significant portion of the financing stack for most real estate deals. However, there are some things to know here, including the ratio between preferred equity and common equity. Both types of equity financing for real estate involve offering shares to investors, but those investors are treated differently throughout the investment.
In both preferred and common equity financing situations, the developer will also own shares. There will also be an operating agreement that stipulates their responsibilities, as well as their rights. In most cases, the developer’s primary responsibility is to handle the day-to-day operations. There will also be an agreement that delineates the rights and responsibilities of the investors in the deal.
Both preferred and common equity investments are riskier than debt financing. That’s because these investors take on some of the risks if the project fails, and the value of their shares varies based on the performance of the property.
There are several advantages to equity investing, particularly when compared to debt investing. For instance, there is no cap on returns, which means that investors have greater earning potential, including annualized returns up to 25%. There are also tax benefits, such as being able to deduct specific expenses that relate to ownership within the investment property. Equity crowdfunding usually relies on an LLC structure, which means that taxes flow through and investors can benefit from depreciation without the need for direct ownership of the property.
Finally, the fees are often lower with equity crowdfunding. Instead of paying fees and monthly service charges upfront, investors may elect to pay a single annual fee calculated as a percentage of the total amount invested. In most cases, it will be between 1% and 2%.
Of course, there are some drawbacks here, too. The risks are higher than with debt financing, which has been mentioned, but there is also a longer holding period. They can be as long as five or 10 years, which will affect investors’ liquidity.
Preferred Equity
Preferred equity (or stock) is very similar to common equity, with the exception that these shareholders are not given any voting rights. They have no say in the future of the company and cannot cast a vote for members of the board or any corporate policy. In many ways, preferred stock resembles bonds in that investors are usually offered a fixed dividend moving forward (in perpetuity).
Still, preferred equity investors do have an advantage over common equity investors in that they have a priority claim over distributions. They will also have a slightly lower return because the risk level is slightly less than what common equity investors face.
Common Equity
Common equity investors have a say in the operations of the company, and they can vote on board members. However, this is a riskier type of financing and, while that means the rewards are slightly higher than with preferred equity, the fact remains that common equity investors are last on the list for repayment and will come behind most other claimants.
Debt Financing for Real Estate
Debt financing is an interesting option that allows developers to raise funds without having to sell shares. That means they get to keep total control over the project and don’t have to worry about investors voting them out or making changes to the board.
Debt financing is also probably more familiar than equity financing, simply because more people understand how loans work. In this situation, investors are acting as lenders to the developer. The investments they make are loans and earn interest over time. They’re a lot like home mortgages or auto loans because the property is used to secure the loans. Investors will receive a fixed rate of return based on the amount invested and the interest rate set. However, these investors are at the very bottom of the capital stack, even below common equity stockholders.
Investors (and property developers by extension) see a lot of benefits with debt financing. For instance, there’s a shorter hold time than with equity investing, usually maxing out around 24 months. This can ease the worries of those who are concerned about their money being tied up for long periods and may help property developers attract more potential investors than with equity alone.
The reduced risk has already been discussed, but debt financing also offers stable, predictable income. Unlike equity investments, which have a return based on asset performance, debt financing offers an annual return of between 8% and 12% annually, although every deal is different. That’s a boon for investors, but it can also be a powerful marketing tool for developers looking to cast a wider net and attract more investors.
However, there are some drawbacks to going the debt financing route. For instance, the returns are capped by the interest rate on the loan. Investors are offered a safer investment experience in exchange for a potentially lower payback. This is good news for investors who crave predictability and have a lower risk appetite and can be a good selling point for developers actively seeking those types of investors. However, it is a drawback for those who want to maximize their earnings and have more appetite for risk.
In addition to capped returns, debt financing often comes with higher fees. These are usually charged by real estate crowdfunding platforms, which means that smaller investors will be required to pay additional fees for using these tools. Higher net worth individuals with pockets deep enough to enter real estate investing on their own will not be affected by this.
Finally, there is always the chance that the real estate developer will pay off the loan(s) early. This interrupts the cash flow process and, while it does return the invested capital, it means that investors ultimately earn less.
Syndicated Debt (AKA Hard Money Loans)
The final type of real estate development financing to cover is syndicated debt, also known as hard money loans. Hard money loans are used throughout the real estate industry to gain access to critical financing when conventional lenders are either too wary or otherwise unavailable. Hard money lenders can offer larger loans than conventional lenders can provide, but they can sometimes offer different types of loans, such as bridge loans.
Syndicated debt is somewhat like other types of crowdfunding financing, with a few key differences. In this situation, the borrower (the developer) will approach a hard money lender and apply for a loan. The lender then does their full due diligence, including background checks, exploring the developer’s project history, and more. If the developer passes the investigation and the loan makes sense, the lender will issue the money.
Once the loan is issued, the lender then turns around and sells portions of the loan to private investors. These investors then own those portions, although they often pay additional fees to the lender. Note that the developer will usually also pay additional fees.
Hard money loans can be beneficial real estate financing tools. As mentioned, hard money lenders are often willing to take a chance on borrowers that conventional lenders would turn away. They can also issue loans much more quickly than banks and other lenders, making them well-suited for those on tight project timelines. However, understand that these loans often come with interest rates much higher than what a conventional lender would charge, which means that while they can be valuable tools, they should be used with discretion.
The Takeaway
Real estate development offers the opportunity to build wealth and reputation. And thanks to digital tools and platforms, it’s now available to those without deep pockets or strong political connections. However, finding the right financing options for any real estate development project remains critical.
Many different financing methods exist, from equity financing to debt financing. Syndicated debt can also play a role. Savvy property developers should understand the breakdown of the average capital stack, as well as the fact that traditional banknotes usually account for up to 80% of the stack.
Each type of financing also requires a firm understanding of the target audience. For instance, developers won’t market the same type of financing opportunity to accredited and unaccredited investors in most cases. Developers will also need to balance the interest rate on their loans. Conventional loans are often around 4% and can last up to 30 years, but hard money loans may only last a few years, but command an interest rate of up to 15%.
With the right due diligence, careful structuring, and the right partners, it’s possible to put together a deal that ensures a project is fully funded, that investors see a good return, and that developers see the success they deserve.