What is Source of Capital in Real Estate

Every real estate investment requires capital in order to fund a project’s cash requirements. There are three main categories, or sources of capital used in real estate projects: debt, equity, and the project’s cashflows. Every real estate project has a unique capital structure that is ultimately set to maximize project cashflows while fulfilling all financial obligations associated with a project. The capital structure for a real estate project refers to the proportion of debt and equity used to fund said project. We will go more into the different types of debt and equity that are commonly used to fund real estate projects and how capital stack proportions are decided.

Debt

Debt as a source of capital is used to fund a project with capital that developers currently do not have. One common form of debt is construction debt, which is a short-term loan that is used to fund the development of a real estate project. Construction loans typically have higher interest rates as the risk associated with the project development is much higher than a traditional project loan. Construction loans are usually interest only. Another common form of debt as a source of capital is senior debt. Senior debt has priority in a project’s capital stack and must be paid first if a real estate project defaults. Since senior debt loans are paid off before any other form of debt, they have the lowest risk, and thus have lower interest rates. Another common form of debt is mezzanine debt, which has the highest risk compared to all other forms of debt as a source of capital. Mezzanine debt is the last form of debt in the capital stack that is paid before equity investors receive returns. Due to the high risk associated with mezzanine loans, interest rates are typically high, and they are typically unsecured as repayment is highly dependent on the project’s performance seen through free cash flows.

Equity

After all forms of debt investors are paid, equity investors can then receive returns on capital invested into a real estate project. There are two main categories of equity investors: Limited Partners and General Partners. Limited Partners are investors that have limited liability as they are only liable up to the amount of their investment. Limited Partners are less involved in the investment and are ultimately hoping to obtain a return on their investment. Conversely, General Partners assume unlimited liability with regards to their equity investment and are in full control of their investments. General Partners are more involved in the investment as they are fully liable and share the profits and obligations of the investment. Ultimately, it is riskier to be a General Partner as a real estate equity investor since you have the potential to lose more on your investment than a Limited Partner can. Below is a portion of Top Shelf Model’s Storage Development Model that outlines the capital stack for a storage project. As seen below, 90% of equity invested is Limited Partner equity and 10% is General Partner equity. Also, as seen in the Capital Stack, all debt capital comes from a construction loan. This means there are no senior debt or mezzanine investors for this project.

Project Cashflows

While debt and equity are the most common sources of capital in a real estate project, the project’s cashflows can be used to reduce debt and equity amounts when appropriate. A project’s unlevered free cash flows are calculated using the project’s net operating income while also considering any capital expenditures, depreciation/amortization of loans, and changes in working capital associated with the project. These unlevered free cash flows can then be used to fund equity requirements and certain project costs if a capital raise isn’t feasible.

Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.