When deciding how to fund a new project, several factors should be considered. In most cases it will be a combination of equity and debt. The question becomes how much of each and under what terms. Whether you are an experienced developer with a preferred funding program or not, here are some things to consider.
- What is the long term strategy for the project? If you plan on selling the project at completion, then a higher loan amount may be preferred to lower the overall cost of capital. However, if you plan on keeping the property in your portfolio you should match your construction loan with the anticipated permanent loan amount. Also, if you are keeping the property long-term, consider whether your focus is on cash flow or long-term value growth. A cash flow focus might indicate a more conservative loan amount for smaller debt payments and more free cash flow.
- Business risk. If your property has a lower risk profile and more predictable cash flows, i.e. apartments or credit-tenant leased commercial property, then a capital structure weighted towards debt is in order. Alternatively, if the property is a suburban office building with turnover coming and in a competitive marketplace, then a capital structure with “room for error”, read more equity, may be preferred.
- Financial flexibility. Loan payments must be made each month. If you are not able to make the payments or pay off the loan at maturity, you risk losing the asset, bankruptcy, or both. When economic signals are mixed or negative, consider a lower debt ratio. The more flexibility the company has during difficult economic periods the better.
- Interest rates. Debt is cheaper than equity and everyone wants positive financial leverage. The wider the gap the more you may want to tip in the favor of debt. Be mindful though that higher leverage can increase the cost of debt. Also, if you think rates will increase dramatically during your hold period, you may want to lock up as much debt today at cheap rates and inventory the cash for future use.
- Lender appetites. During different phases of the real estate cycle lenders have varying levels of aggressiveness, or complete lack of interest, for making loans. So a key factor in deciding how much debt to use is knowing how much you can get. The cap may be set for you.
- Outside investor appetites. Most developers use some amount of equity from third parties. Investor appetites change with the market as with lenders. Their requirements for return, leverage, providing loan guarantees, and terms and control will vary. Investors will require higher returns and more influence the riskier the project is.
- Consider your current portfolios’ capital structure.
- Do you have a lot of leverage already?
- Do you need capital/cash on hand for other upcoming projects?
- Are there any loan covenants with existing lenders that may impact your capital strategy for this new project?
- If you want non-recourse loans, then more equity may be required in the deal.
- Tax considerations. Typically, debt is desired as interest is tax-deductible. However, if you have a significant investor who has net operating loss carry-forwards, they may be able absorb income with a positive tax impact, allowing you to borrow less.
- And finally, what is your appetite for risk? Everyone has their own temperament towards risk and debt. Some folks are comfortable with a higher leveraged, more risky capital structure, and others prefer more equity for the opposite reasons.
Of course, there are a myriad of options to consider when capitalizing a project. For instance, one might have a third level of mezzanine debt in the mix or an institutional investor who prefers 100% equity.
I hope this has added a little food for thought.