The Basics of Real Estate Finance

Real estate development financing falls into two primary categories: debt and equity. Debt financing receives a return based on fees and an interest rate, either fixed or variable; equity financing receives a return based on project performance. Although equity investors are technically the owners of a development project, lenders are actually in a senior position in the financing “capital stack,” because their interest in the project is senior to the interest of the equity investor and is secured by the underlying real estate. If the owner fails to pay debt service, the lender can foreclose on the property, resulting in the lender obtaining ownership of pledged real estate assets. The risk to the lender in any development deal is lower than the risk to the equity investor, so the lender’s returns (the interest rate and fees that it charges for the mortgage) are lower as well. Thus, the cost of debt capital is generally much lower than the cost of equity capital because the lender is in a far more secure position than the equity investor. For this reason, developers tend to use as much debt as possible when financing a project.

To minimize their risk, lenders establish underwriting criteria that vary with market conditions and limit the percentage of project cost or value that they will fund; these limits are expressed as loan-to-value (LTV) or loan-to-cost (LTC) criteria. They are established so that if the project stops performing well enough to pay its debt service, lenders can recover all or most of the debt principal through foreclosure. Foreclosure gives the lender sole ownership of the project, wiping out the value held by the equity investors.

Equity investors receive their return from the project revenues available after paying operational costs and debt service, in other words, from profits. These profits are usually distributed hierarchically in a “waterfall” to a series of equity investor “pools",” each of which has a different rate of return and position in the capital stack. In addition, profit on a sale or refinancing of a project has its own formula for distribution.

A higher debt percentage means higher “leverage” that is, a higher percentage of the project financed with debt. Higher leverage means lower financing costs on a greater percentage of project costs; thus, after paying debt service, profits produce higher returns to both the developer and the smaller amount of capital required from equity investors. As a consequence, developers and equity investors usually seek high leverage; however, doing so also raises the risk for the investors. Consequently, many investors, such as pension funds and high-net-worth individuals, avoid high leverage and accept lower rates of return on equity for the reduced risk of losing a highly leveraged project to the lender if the project performs below expectations and cannot pay debt service.

The financial viability of a real estate project is based on how its value compares with its costs. Both of these factors are influenced by ever-changing conditions in the capital markets that affect several aspects of financing and viability: the amount of leverage available to a project; interest rates; the loan terms, such as guarantees and recourse provisions, capitalization rates; and returns needed to attract capital to real estate over competing investment classes such as stocks and bonds.

A word about terminology: Like other areas of human endeavor, real estate financing has its own terminology or buzzwords. Shorthand terms of the industry include waterfall, “pari passu,” capital stack, “recourse,” “cap rate,” ‘DCR,” LTV, LTC, “mezzanine,” and “promote,” as well as many more. They can be bewildering and intimidating to a beginning developer. We will attempt to explain as many terms as possible and include a glossary for reference in future blog posts. But in the real world, different terms are frequently used for the same concept. So as you read through further blogs, understand the concepts and pick up as much of the terminology as you can, but do not be intimidated when you encounter terminology in the real world that you do not understand. Ask what it means! The concepts are not that complicated, and you should never allow unfamiliar financial terminology to obscure your understanding of the concepts.