Whenever you see a new project being built in your neighborhood, there is typically a single real estate entrepreneur (usually known as a developer) that is credited as the owner. The developer garners the majority of the public attention, and receives both the accolades and criticism that come with the project. What most people don't know is that this developer has, in fact, only invested a small fraction of the total money needed for the project.
Funding a Real Estate Deal: Debt and Equity
In almost all real estate deals, both debt and equity play enormous roles. Most projects require some level of traditional bank debt. Whether the project costs $1 million, $10 million, or $100 million, a bank is normally involved, providing 60%-80% of the total capital.
So for a $10 million property, a bank might lend $7 million (70%) of the capital, leaving $3 million of equity required. The bank will charge an annual interest rate on the loan they make but will not receive any actual ownership in the property.
So where does the $3 million of equity come from? The developer will then raise 80%-95% of the remaining capital from investors. So in the example above where the developer raised $7 million in debt, he might then raise $2.7 million (90%) of equity from investors and invest $300,000 (10%) himself.
Developer: $300,000 (3%)
Investors: $2,700,000 (27%)
Bank: $7,000,000 (70%)
While 3% may not sound like much, $300,000 is a fair amount of money for a single individual or small team to have available as cash. This becomes even truer when you realize that many real estate projects are much larger than $10 million and most real estate developers usually have several projects going at any one time. In short, it adds up.
If you are interested in more details, here is an example of real estate development financials for a property in Washington, DC.
These financial breakdowns also raise a question: if the real estate developer is only providing a fraction of the equity, who is investing the remaining 80%-90%?