Financial structuring of a real estate development - equity vs. debt

Initiating a real estate development is similar to starting a new business from scratch. It’s unlike purchasing a stock on the stock market that pays immediate dividends or even a property that’s fully built with a tenant and revenue already in place.

Developing a commercial real estate property means putting up a lot of money for purchasing land, building the property, and then maintaining the property until stabilization. Depending on the size of the property, the complexity of the development, how speculative the development is, and numerous other factors, this can be an extremely long and risky endeavor. Developers need sources of both debt and equity financing that are tolerant of this risk in order to fund the project.

In this article we’ll discuss the forms of debt and equity that could be obtained for the development of a commercial real estate project along with some of the pros and cons of each type of financing.

The capital stack

The two main types of private financing a developer can obtain are debt and equity. Debt is usually provided by a lender, such as a bank or other institutional investor. Equity can be provided by any number of parties, from large institutions to private family offices or even individuals. And within each of the debt and equity categories are subcategories of each, such as senior or mezzanine capital for debt. Equity can be a mix of preferred or common equity. We’ll briefly discuss these subcategories below.

The combination of all of the different types of financing for a commercial real estate development is commonly known as the “capital stack” and provides a representation of not only how much of each type of financing is provided, but also the order of precedence each type takes in the project. The image below is a visual representation of the capital stack.

The percentage split between the different types of capital is often very flexible and not every project will have every type of capital involved, so the numbers provided above should be used only for a conceptual understanding of the capital stack. Some projects may even have other types of financing, such as government grants, as part of the capital stack.

The order of precedence in the capital stack goes from bottom to top, as does the level of risk for each type of capital. Senior debt has the highest priority of cash flows of all the types of capital and common equity has the lowest priority of cash flow. The flipside to the priority in cash flow is the potential return.

Senior debt charges an interest rate, either fixed or floating, but the return to the lender is limited to the rate of the interest charged. Common equity, on the other hand, has almost unlimited potential in the level of return it can earn. As you move up the capital stack from senior mortgage debt to junior mortgage debt, etc., each type of capital bears more risk and more potential return. As you can see, the fundamental rule of risk vs. return holds in commercial real estate financing. The capital providers who are exposed to the lowest levels of risk are also limited in their return.

The types of financing

Senior mortgage debt

Senior mortgage debt is often provided by institutional lenders (large banks or pension funds, for example) and typically makes up the bulk of the capital for commercial real estate developments.

The lender charges some form of interest rate on the funds provided, either in the form of a fixed interest rate or a floating interest rate. In the capital stack shown above, the senior lender is providing 60% of the capital needed for the development of the project.

Again, keep in mind that these percentages are used as an example only and most projects will have different percentage splits between the capital types.

Senior debt is secured by a deed of trust on the property, meaning the lender can foreclose and take ownership of the property in the event that the owner/sponsor fails to keep the debt in good standing. This means that the lender has the ability to take back ownership of the property and then either sell the property or the loan to recoup as much of their capital as possible, ultimately lowering the risk exposure of the senior lender.

Junior mortgage debt

Junior mortgage debt is simply a smaller loan that sits above the senior loan in the capital stack. Some projects will have junior mortgage debt and some will not.

The big difference between senior and junior mortgage debt is that the junior debt has a lower priority on cash flows than senior debt (though still higher in precedence than equity) and charges a slightly higher interest rate on the capital provided.

Many times, the capital above the senior loan will come in the form of mezzanine debt or preferred equity instead of a junior mortgage loan (discussed below), but often serve the same purpose of bridging the gap between the amount of common equity needed and the amount of debt provided by the senior lender.

Mezzanine financing

Mezzanine financing sits in the middle of the capital stack between debt and equity capital and can take on the form of either type of capital. If the mezzanine financing for a property is structured more as a type of debt, it charges a higher rate of interest than the senior mortgage loan (similar to that of the description of junior mortgage debt above).

If structured as equity, it can take the form of a preferred equity stake (discussed below). Mezzanine capital has lower priority to cash flows and has more limited rights of foreclosure than does the senior lender. Mezzanine providers enter into agreements with the senior mortgage lender, called “Intercreditor Agreements,” that lay out the options provided to the mezzanine lender in the event of a default by the borrower.

Preferred equity

Preferred equity is a unique type of capital, offering some characteristics of debt and some of equity. Preferred equity has a required rate of return and also typically shares in the upside of the returns of the property.

For example, the preferred equity agreement could call for the preferred equity provider to receive a 7% return before any cash flow is provided to the common equity holders. The preferred equity holder then can receive a portion of any upside the property achieves beyond the 7% required rate of return.

Common equity

Common equity is the last in line in the capital stack. The common equity is usually provided by two parties: a General Partner and Limited Partner(s).

The General Partner (GP) in a project is an active partner, handling the day-to-day operations of the development, such as identification and acquisition of the property, development and construction, lease-up (or sale), and operational aspects of the property once the development is completed. The Limited Partner(s), also known as “LP’s,” are usually passive investors in the project.

As mentioned above, common equity is last in line for cash flow, making it the most risky portion of the capital stack. But it can also be the most lucrative, with almost unlimited return potential if the project becomes very successful.

Comparison of debt and equity

There are many factors that need to be considered when determining how to structure the capital stack for a commercial real estate development. In reality, most projects do not include all of the types of financing described above.

It’s not uncommon for a project to have only senior debt and common equity, or perhaps a piece of mezzanine capital as well. Each project will be structured differently and should be based on the specific characteristics of the project and the parties involved. Also, the terms and conditions of each type of financing will play a major role in determining which type of financing is right for each project.

Often the owners/sponsors of the project will choose to pursue capital in the middle of the stack, such as mezzanine or preferred equity, as a result of a lack of sufficient equity capital on the part of the General Partner or simply a result of trying to receive a higher return by placing more leverage on the project. However, higher leverage could increase the risk of default and completely wipe out any equity component along the way.

Structuring the capital stack should be based on a holistic analysis of the project, the parties, the market, and the risk tolerances of all players. Also, a deep understanding of the strategic role each type of financing can play in the success of the project is essential.

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