Which Comes First – Debt or Equity?
Does this sound familiar – I want to buy this abandoned or under-utilized property and I need to figure out how to fund it. Depending which side of the table you are on, the approach can be quite different. The first question a potential lender will ask is “how much equity will ownership have in the deal?” The first question a potential equity source will ask is “how much financing can be secured?” Which brings us to the age old chicken and egg question – which comes first… debt or equity?
I recently attended the NY Multi-Family Summit at NYU where an esteemed panel of banks, insurance companies and a mortgage broker were asked “What drives real estate transactions today – debt or equity?” Not surprisingly, the lenders all said “definitely the debt.” The mortgage broker, however, said “definitely the equity,” which I happen to agree with. If the project has solid merits, it’s generally financeable but unless the developer has pre-existing equity sources, the equity is generally more difficult to secure and much more costly to the developer’s bottom line.
As the real estate market continues to overheat, and with due diligence periods and margins getting compressed, the best advice I give my clients today is that both debt and equity are equally important and must be evaluated simultaneously. Progress Capital can very quickly analyze the amount of financing that would be available for the project based on a set of circumstances such as purchase price, construction/renovation costs, carry costs, etc. Once a realistic debt level is determined, we then confer with the client to figure out the equity required and the cost of the equity. Will it have a preferred rate of return? What will the splits be between GP and LP and how will that change once the equity and preferred return are repaid? Most importantly, is there enough profit margin in the project to repay the equity over a reasonable period of time?
Advantages of Debt – Debt can be a useful tool in financing a project and is less expensive than equity which is why the highest level of debt is generally the goal. If the property is being developed or renovated, an interest reserve can be built into the loan to cover debt service until the property is stabilized. Another advantage of using debt over equity is that lenders, unlike investors, don’t have a say in how the project is managed.
Downside of Debt – If the project is not stabilized, mortgage payments cannot be deferred and will result in a default if not paid timely. Debt, especially for non-stabilized properties, may require a personal guarantee which could affect the financial net worth of the developer.
Advantages of Equity – Equity provides a welcome alternative to debt for many projects as it does not constrain current cash flow and eliminates the personal guarantee. Another advantage of equity is that you don’t have to repay equity immediately and if there is a loss, it is shared among the partners. Equity partners sink or swim alongside the developer.
Downside of Equity – The largest disadvantage of equity is loss of control. By taking on equity you give up partial ownership and, in turn, some level of decision-making authority over your project. An equity partner may demand a large percentage of ownership until such time as the funds are returned, and will likely have rights to step in and take control of the project should a problem arise. Since the equity partner is behind debt in priority, he will look to protect his investment at all costs – usually to the detriment of the developer. Equity partners also have a shorter time horizon on repayments than debt.
Kathy Anderson is the Founder of Progress Capital, a commercial mortgage banking firm that has closed over $40 Billion in commercial loans and directly funded over $150 Million in interim financing.