Real Estate Debt vs Equity Partners

[Benjamin Holt]

I recently started working for a development company and am essentially trying to learn a huge portion of the industry I am unfamiliar with. One of the biggest things I've had a little bit of trouble wrapping my brain around is the difference between debt lenders vs equity lenders. I understand that if you're working with a debt lender, it's essentially similar to borrowing from a bank.

Could someone explain to me in the SIMPLEST way possible, how the equity process works?

Let's say, just to keep math simple, that we are trying to raise $1 million dollars for a 50 unit multi-family complex and we're looking for equity partners to do so. How does this process work? How do they make their money? How do we make our money?

Any information would be greatly appreciated.

Thanks

[Bryan Hancock]

There are various parts of the capital stack for real estate projects.  Deals are generally capitalized (funded) as follows:

1.  Debt - Debt comes in various forms with many different features, but in simple terms you borrow money and agree to pay the lender back at some periodic interval (generally monthly) and they charge the borrower an interest rate for "renting" the money.  There are recourse loans and non-recourse loans.  There are secured loans and unsecured loans.  There are commercial loans and residential loans.  There are all sorts of other features too, but these are the basics

2.  Mezzanine Financing - I am not going to write a lot about this because it really is only used for larger projects, but this claim on profits sits between senior debt (Item 1 above) and Item 3 below.  It generally carries a higher interest rate

3.  Equity - Equity represents a claim on profits from a project and is generally more expensive capital.  The "equity lenders" (not really a thing, but to use your language above) have some claim on the overall equity participation in the project according to the agreements put together.  This generally takes the form of a legal entity (partnership or operating agreement), a disclosure document (PPM, offering circular, etc.) and subscription agreement (legal agreement for shares).  

From a sponsor's perspective all of the above are claims on profits or operations at various intervals during the project.  Debt is paid first at the project's reversion cash flow or during liquidation.  Mezzanine financing is paid next and equity, the most junior part of the stack, is paid last.  The sponsor's portion of the equity is generally paid LAST and is the most risky position in most projects. 

As you migrate from most senior (debt) to most junior (equity) parts of the capital stack the return requirements go up.  More risk means higher demanded returns from investors.  Debt right now is in the 4-6% range and equity is in the 10% - 20% range for most project types.  So equity is roughly 2 - 3 times more expensive for many project types.  The notable exception is fix-and-flip projects because the duration is so short.  Hard money loans are common for this product type.  

Hopefully this helps some....happy to elaborate if needed.