How Real Estate Development Projects Are Funded
Have you ever driven by a building or apartment complex being built and wondered, who is building that? For most projects that you see being built, there is typically a single real estate entrepreneur (known as a developer) that is credited as the owner (the brains behind the project). The developer garners the majority of the public attention and receives both the praise and criticism that come with the project. What most people don't know is that a developer has, in most cases, only invested a small fraction of the total money needed for the project.
Funding a Real Estate Deal: Debt and Equity
The two biggest factors in any real estate development deal are debt and equity. Most projects require some level of traditional bank debt. Whether the project costs $1 million, $10 million, or $100 million, a bank is normally involved, providing anywhere from 60%-80% of the total capital.
For example, typically on a $10 million property, a bank might lend $7 million (70%) of the capital, leaving $3 million of equity required. The bank will charge an annual interest rate on the loan they make but will not receive any actual ownership in the property.
The developer will then be tasked with raising the other $3 Million required of the project. 80%-95% of that remaining capital will come from investors. So in the example above where the bank put up $7 million in financed debt, the developer will put in 10% of their own money ($300,000) and will then have to raise the remaining $2.7 million (90%) of equity from investors.
Here’s how it looks on a balance sheet for the total development amount:
Developer: $300,000 (3%) Investors: $2,700,000 (27%) Bank: $7,000,000 (70%) Total: $10,000,000
While 3% ($300,000) may not sound like much for the developer, it is a fair amount of money for a single individual or small team to put up. The Developer is also responsible for securing the initial bank loan and managing the cash draws, the construction, and contractors building the project. They are on the hook for making sure the project gets completed and everyone gets their investment back with interest. This becomes even bigger when you deal with even larger projects than $10 million. Most real estate developers usually have several projects going at any one time, so it quickly adds up.
Who Really Owns Most Real Estate Development Projects?
While developers have their names attached to projects the vast majority of equity is coming from outside investors: high net worth individuals or large investment funds. These outside sources of capital are, in fact, the major drivers of how projects get developed – ultimately those outside investors are the majority owners of most properties.
In today's world, raising money from individuals is very inefficient and time-consuming and as a result, most developers choose to raise money from private equity funds.
When a private equity fund invests in a project, it typically holds a super-majority of the equity and therefore keeps the governance rights over major decisions and ultimately has the power. This can cause large problems for developers if they don’t stick closely to the agreed-upon business plan.
Over the last decade, Private Equity Funds and Real Estate Investment have become the primary driver of real estate development. Real Estate Investment funds allow small investors to become part of lucrative real estate markets at fairly low risk as well as allow developers to create more projects for neighborhoods.
Investing in real estate has always been one of the most effective paths to financial independence. That's because it offers incredible returns and even more incredible tax breaks. Make sure you are partnering with a credible developer like BHI Construction & Real Estate Development.