Capital Formation: How to Get Money for a Deal
Real estate projects rely on injections of capital during the development, acquisition, and refinances phases. Using a needs and sources table, plan the needs of a project and then turn to various sources to obtain the needed capital.
Identifying Capital Needs
Before searching out sources of capital, identify the needs of a project. Capital formation usually occurs at three points in a project:
- Asset acquisition;
- New property development; and
- Refinance of existing property.
To start creating a capital plan, draft a Sources and Uses table. First, on one side, identify the needed funds under “uses.” For example, capital needs may include the property purchase price, renovation costs, financing costs, and more. That creates the project’s budget. Then, build up the capital sources until you reach the budgeted amount.
Types of Capital
Real estate projects rarely rely on a single source of capital. Instead, funding comes from a variety of sources known as the capital stack. We think of the capital stack as a series of layers, with each one telling us who has the priority to income generated and who has the first right of foreclosure.
Senior debt creates the bottom level of the capital stack and has the first priority for repayment. Traditional mortgage loans where the property is the collateral are the most common source of senior debt. Typical senior loan sources include banks, online lenders, government agencies, credit unions, and life insurance companies.j
Because there are many sources, commercial borrowers often use a mortgage broker to help them find the best rates and most promising lenders.
Mezzanine, or Mezz, debt, follows in priority after the senior debt. Mezz debt is typically characterized by less favorable terms to the borrower, like higher interest rates and fees. Whereas traditional lenders usually finance senior debt, Mezz debt often comes from private debt funds or individuals making hard money loans.
Senior and Mezz debts create liens against the property. Alternatively, equity financing gives providers of capital an ownership interest in real estate. Among the equity partners, those with “preferred” status enjoy senior income and capital repayment claims.
Finally, at the top of the capital stack are the equity partners, comprised of general and limited partners. They shoulder the highest level of risk because they are the last to be paid, and consequently, have the opportunity to see the most significant returns.
Limited partners are passive investors who provide capital for the project, whereas the general partner is the sponsor of the endeavor. Sponsors are responsible for executing the project plan, and with that burden comes the possibility of earning a high amount of profits from a deal.
Takeaways for Investors
This tiered financing system gives investors various options for finding funds to run a commercial real estate project. But, of course, anyone contributing capital should always know where they land within the capital stack to best assess the possible risk and reward.