In real estate, financing is king. Without an effective plan to raise money, even the best deals won’t get off the ground. As a result, experienced developers form detailed plans to finance projects during their earliest stages – both with debt and equity. In this article, we’ll focus on the latter, explaining how to find investors for a real estate development deal.
Specifically, we’ll cover the following topics:
- Identifying a Development’s Cash Needs
- Potential Real Estate Development Investors
- Final Thoughts
Identifying a Development’s Cash Needs
Most developers finance projects with a combination of debt (i.e. a long-term mortgage) and equity (i.e. investor contributions). Generally speaking, the size of the loan drives a project’s equity, or cash, needs. But, before seeking investors, a developer first needs to accurately forecast 1) total project costs, 2) maximum debt financing, and 3) the resulting cash gap. With this cash gap identified, developers can begin the process of bringing outside investors into the deal.
For example, assume a developer plans a ground-up apartment building. Total costs (acquisition, holding, soft, and hard construction) equal $18,000,000. The lender’s initial appraisal values the post-construction, stabilized property at $20,000,000. The lender then offers an acquisition/construction loan at 70% loan-to-value, or $14,000,000, based on the projected stabilized value. Upon property stabilization – typically 95% leased for multifamily properties – this acquisition/construction loan converts to a permanent mortgage with the same lender.
With total project costs of $18,000,000 and an acquisition/construction loan facility of $14,000,000, the developer has identified a cash gap of $4,000,000. Armed with this information, he can begin the process of raising equity financing via outside investors. However, this begs the question, how can real estate developers find investors? In the next section, we’ll review some considerations behind several common investor pool options.
Potential Real Estate Development Investors
Individual Investors
Many new developers leverage relationships with friends and family when they first begin raising funds. Finding investors hinges on trust, and for new developers, it can be difficult to establish this trust without a track record of successful deals. On the other hand, individual friends and family members are more likely to invest, as they already know and trust these new developers, regardless of their relatively limited experience.
Syndications
In commercial real estate, developers often find great deals but lack the capital to make them happen. Conversely, many passive investors want a return on their investment but lack the time or expertise to find and execute a real estate deal.
Real estate syndication solves both problems. In this system, a deal syndicator (also known as a sponsor), finds, underwrites, and vets a commercial real estate deal. This sponsor can personally develop these deals or raise funds on behalf of a developer. Next, the sponsor pitches the deal to potential investors. In a commonly-used syndication model, the investors receive a minimum required return – paid out prior to the syndicator receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the syndicator receives a disproportionate amount of that upside through his catch-up return and promoted interest distributions.
Institutional JV and Preferred Equity Partners
With a joint venture, two or more businesses pool their resources to pursue a single project. These shared resources often include capital, technical expertise, and contributed services (aka “sweat equity”). Institutional investors are companies that invest funds on behalf of other individuals (e.g. mutual funds, insurance companies, pension funds, etc.). Accordingly, institutional JV involves entering a joint venture as a capital member (i.e. investor), while the developer generally serves as the other member of the venture.
Frequently, institutional JV investors join deals as preferred equity partners. On the capital stack, preferred equity is junior to debt financing but senior to common equity. As such, these investors typically receive a preferred – or required – return on their capital. And, in a successfully executed deal, they’ll receive a share of the deal’s upside as equity holders – albeit at a lower rate than the common equity holders.
Family Offices
A family office provides full-service wealth management to extremely high-net-worth individuals. These offices provide total solutions to managing the investment and general financial needs of these wealthy individuals and families. As a result, many family office managers seek investment opportunities to diversify their clients’ portfolios. In pursuing this diversification, family offices often look beyond more traditional stock and bond investments and join real estate development deals as limited partners or investor members.
Private Equity Funds
Private equity funds raise investment capital on behalf of institutional and accredited investors. With a certain threshold of capital raised, these private equity funds would traditionally buy and manage companies before selling them – ideally at a significant return. Accordingly, private equity typically includes sums of money far greater than any of the above investor pools.
However, capital from private equity funds has begun to flow into real estate holdings – not just purchasing companies. As such, large enough development deals can potentially attract investments from real-estate-focused private equity funds. Or, more realistically, a portfolio of development deals could attract private equity investments.
Final Thoughts
Once again, when it comes to successful real estate developments, financing is king. While most new developers are inherently familiar with debt financing, raising equity can prove more unfamiliar and challenging. However, by considering the above pools of potential investors – and their unique considerations – developers can create a clear, executable financing plan for a project.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.