Sources of Capital in Real Estate

Sources of Capital in Real Estate

Sources of capital used to fund projects come in the form of debt, equity, and cashflows. In real estate, these can be broken down into more specific categories listed below:

Debt

Construction: Construction debt is a short-term loan used to fund the development of a real estate project. The developer borrows money in the form of a construction loan to cover the costs of a project before receiving any long-term funding. Due to high risk, construction loans have high interest rates as compared to traditional loans.

Senior: Senior debt refers to a loan that must be repaid first if a project fails. In the capital stack, senior debt is at the bottom, indicating that it is the safest loan due to priority over others in case of foreclosure/default.  This form of debt is typically secured by a lien against some type of collateral. Due to the low risk factor, senior loans commonly carry low interest rates.

Mezzanine: Mezzanine debt bridges the gap between debt and equity funding and is considered the highest risk form of debt. They are subordinate to all other forms of debt but are senior to equity. They are often unsecured and are based on a company’s ability to pay back with free cash flow. Therefore, they usually charge a much higher interest rate compared to senior debt and other subordinate debt.

Equity:

Limited Partners (LP): Outside investors in an investment firm are commonly referred to limited partners. They have limited liability and limited management control on the investments. LP’s are usually just interested in the return on equity capital provided to the fund to carry out their plans.

General Partners (GP): General partners share profits and liabilities of a company. Unlike LP’s, they have unlimited liability for all debts and generally assume full management control of the entity. The equity capital put in by GP’s are small compared to debt funding as well as equity funding from limited partners.

Project Cashflows:

In real estate, the net operating income (NOI) from a certain project can be used to offset project costs and reduce equity needs. This is not a primary source of capital but can provide some if necessary.

Example:

Below is an example of how sources of capital are demonstrated in the Top Shelf Model’s Multifamily Development Model:

In the model outputs section above, we can see that this project is financed with construction debt, mezzanine debt, and equity. The equity capital will be funded by the limited partners (85%) and general partners (15%). 

Total (capital stack) = Total (project costs)

Total Sources = Total Uses.

In the waterfall section of the model, we can see that the limited partners provided $4,674,287 and the general partners provided $824,874 to fund the equity portion of this project.

This ties back to the model outputs above that states the equity capital is funded 85% by LP and 15% by GP. This covers the $5,341,543 total equity funding needed.

Total Budget – Construction Debt – Mezzanine = Equity

$27,366,172 - $20,524,629 - $1,500,000 = $5,341,543

Conclusion

Debt, equity, and sometimes cashflows can be used to fund costs associated to real estate projects. Debt and equity can be broken down into the following categories:

Debt: Construction, Senior, Mezzanine

Equity: Limited Partner, General Partner

Combinations of these two forms of debt are used to finance the majority if not all the project costs. If needed, a company can further fund the project through the use of the cashflows that it generates.

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About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions regarding discounted cashflows or if he can help you with your modeling needs.