When you buy a home, you usually need between 3.5% to 20% of the purchase price in cash. With large commercial real estate deals, you also need to bring cash to the table. But, with significantly higher valuations, finding enough cash – or equity – to close on an apartment building poses a major challenge. As such, we’ll use this article to explain where to get equity for multifamily deals.
Specifically, we’ll cover the following topics:
- What is Equity in Commercial Real Estate?
- Why Equity Financing Matters for Multifamily Deals
- Where to Find Equity for Multifamily Deals
- Final Thoughts
What is Equity in Commercial Real Estate?
From an accounting perspective, equity refers to ownership. That is, how much does someone own in a given asset? Say, for example, you buy a single-family home. If you purchase the property for $400,000 using an 80% loan-to-value (LTV) mortgage, you would need a 20% – or $80,000 – down payment. As a result, you would have $80,000 in equity – or ownership – in the property immediately following the purchase (assuming the value remained constant). The bank would have a lien on the remaining $320,000 due to the outstanding mortgage.
But, in this example, you would also have 100% of the equity in the property. That is, once you pay off the mortgage, you will own 100% of the home. If the value increased to $500,000, you would have $500,000 in equity. Conversely, if the value decreased to $300,000, you would only have $300,000 in equity. In this respect, equity and contributed capital are related – but not identical – concepts. At the outset of a deal, an investor’s contributed capital often equals equity in dollar terms. But, as you pay down a loan and a property’s value changes, your dollar equity will change, but (barring a change to the deal structure) your percentage equity will remain constant.
This leads into a key distinction in commercial real estate: equity versus debt financing. When you raise capital for a deal by selling an ownership stake, you use equity financing. Alternatively, you can borrow money from a lender – similar to the above example – with debt financing. Most commercial real estate deals use a combination of both financing sources. And, when people discuss finding equity for commercial real estate deals, they mean raising capital by selling ownership interests in a given deal.
Why Equity Financing Matters for Multifamily Deals
Having explained equity in commercial real estate, equity financing matters for multifamily deals due to two primary reasons: scale and risk.
Rather than the above example of a $400,000 single-family home, say you want to purchase a stabilized apartment building for $5,000,000. Assuming you can secure the same 80% LTV financing, you would need $1,000,000 in cash for the down payment (ignoring closing costs). In terms of scale, coming up with $1,000,000 will likely pose far more of a challenge than finding $80,000.
Recognizing this reality, many CRE professionals find other investors to help raise enough cash to make a deal happen. In this example, you know that your maximum debt financing is $4,000,000, meaning you need $1,000,000 in equity financing to close the deal. Let’s assume you have $250,000 of your own cash, so you need to find someone willing to invest another $750,000.
With this structure, you would need an additional $750,000 in contributed capital from an investor. This would translate to $750,000 in initial equity and a 75% equity percentage. In other words, for $750,000, an investor would purchase a 75% ownership interest in this apartment building. In doing so, this equity investor would enable you to close on the deal, with you keeping a 25% interest for your $250,000 in contributed capital.
Including equity investors in a multifamily deal also helps to mitigate risk. With debt, you must make your loan payments every month, regardless of a property’s performance. As such, too much debt in a deal can significantly increase the risk profile of that deal.
On the other hand, equity financing provides downside protection. Say that, in a given quarter, your property’s vacancy skyrockets, crushing your quarterly net operating income. Regardless of this poor performance, you still need to service your outstanding debt. But, you do not need to provide returns to equity investors.
In many CRE deals, equity investors collect a pro rata share of a property’s free cash flow – usually on a quarterly basis. If you have $100,000 in cash to distribute, a 50% equity investor would receive $50,000. If you have no money to distribute, that same 50% equity investor wouldn’t receive any distributions. In this fashion, equity investors take some upside from a deal, but they also provide significant downside protection.
Where to Find Equity for Multifamily Deals
If you need to find equity investors to make a multifamily deal happen, here are a few common options:
Wealthy Americans have financial advisors. Ultra-high-net-worth Americans have family offices. Frequently, families with significant wealth outsource their investment and financial activities to these private wealth managers. These managers in turn develop investment plans tailored to the objectives of a particular family. And, many of these tailored financial plans include commercial real estate exposure, making family offices an outstanding source of equity for deals.
Most people view real estate investment trusts (REITs) as a potential investment. But, on the other side of the coin, many REITs don’t actually execute the individual deals in their portfolios. Rather, they invest in deals that an individual sponsor finds, underwrites, and executes. Accordingly, if you need financing for a solid deal, you can submit an offer to a REIT. The staff will then review the deal and, if it supports the REIT’s investment criteria, they will join as equity investors.
Private Equity Funds
Private equity funds pool investors’ money with active managers. These managers then screen potential real estate deals and, potentially, invest in those deals. If you – as a sponsor – find an outstanding deal, you can provide an offering memorandum to a real estate-focused private equity firm. If the deal’s numbers and traits align with the private equity firm’s objectives, it will join as an equity investor.
For new CRE investors, personal relationships represent some of the most reliable sources of potential equity investors. These people know and trust you, meaning you don’t need an introduction and thorough vetting process to make your pitch. But, once you find a multifamily deal to propose to friends and family, don’t view it as a request for charity. It should be a win-win. You receive the equity financing to make a deal happen, and someone close to you generates great returns on his or her investment.
Commercial Real Estate Brokers
You can also always connect with equity investors through CRE brokers like us. At High Peaks Capital, our goal is to connect the key players in multifamily deals. On one hand, we work with sponsors who find and underwrite potential deals. On the other hand, we work with individuals who would like to invest in these sorts of deals – but don’t know how to find them on their own.
Even after outlining the above options, we recognize that finding equity for multifamily deals can be a challenging process. That’s why we’re here to help.
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 multifamily real estate investment opportunities.