PROJECT FUNDING – DEBT VS EQUITY FINANCING?

The two components of commercial real estate financing are debt and equity. In evaluating debt vs equity, each type of financing has its pros and cons. Certainly, to know how much of each to use, it’s important to understand how each works. Also, you should consider how much each cost and what factors should influence your financing mix, your capital stack. Truly, the choice of debt vs equity is one of the most important decisions a developer can make. In this article, we define “What is debt financing?” and “What is equity financing?”. Then we consider key differences in debt financing vs. equity financing, help you decide which is right for you, and answer FAQs.

What is Debt Financing?

Commercial real estate (CRE) debt financing occurs when an investor or developer borrows money for a property or project. Essentially, CRE long-term debt investments are mortgages. Developers use shorter-term debt to acquire, build and renovate properties. Eventually, the owner will take out these short-term loans with a permanent loan.

Typically, a CRE investor will use 55% to 85% debt financing. However, if the investor adds mezzanine financing, debt might account for as much as 95% of the total capital stack. Every dollar that investors borrow is one less of their own dollars they must use. In this way, debt investments leverage the equity an investor sinks into a property.

Cost of Debt vs Equity

The cost of debt is easy to understand. Simply, it is the interest rate a lender charges you for a loan. To get the after-tax cost, multiply the interest rate by (1 – T), where T is your tax rate. Realistically, lenders can use many factors to calculate how much interest to charge you. Fortunately, they can simplify this calculation by estimating the risk that you will default on your loan (i.e., credit risk). That is, the interest rates a lender will charge equals (the risk-free rate + your credit risk rate).

For example, suppose the risk-free rate is 4% and you receive a loan offer of 9%. Then, you know you are paying a 5% risk premium. The more collateral (equity) you put into a deal, the lower your credit risk, which can reduce your cost of debt. Any origination fees or points are additional interest that raise your cost of debt. The cost of debt investments is crucial to deciding the debt vs equity question.

Leverage

Leverage is important when evaluating debt vs equity. Debt adds leverage to a project or property deal. We can illustrate this with an example:

All Equity Case: You acquire an old office building for $5 million in cash and invest another $1 million for renovations. You then sell the building for $8 million, representing $2 million in profit. Your cash-on-cash return is $2 million divided by $6 million = 33.33%.

Debt and Equity Case: Instead of contributing $6 million to purchase and renovate the office building, you use 70% debt financing. In other words, you contribute $1.8 million in equity and borrow $4.2 million. You still make a $2 million profit, but your cash-on-cash return is $2 million divided by $1.8 million which is equal to 111.11%! Thus, using debt in the capital stack levered up your cash return by an additional 77.78%, a huge increase!

The amount of debt you use helps determine the cash-on-cash return you earn. If you had been able to use all debt, your cash-on-cash return would be infinite! Astonishingly, in some situations, you can indeed achieve up to 95% debt, by using mezzanine financing. That is, you take out a mezzanine loan to recoup all or most of the equity you originally contributed to the project. However, you might have to share a large percentage of your profit with the mezzanine loan provider. The availability of mezzanine financing substantially impacts the debt vs equity decision.

What is Equity Financing?

Equity investing involves one or more investors purchasing a portion of a project or property. In return, they receive a share of income and capital gains. Equity investors risk net operational losses and capital losses when they invest. Furthermore, they receive no guarantee that they will achieve their desired return on their investments. Obviously, the more equity you contribute, the less debt you will need for financing the project. This is a central concept for evaluating equity vs debt.

Cost of Equity vs Debt

The cost of equity is the equity investors’ required rate of return. For CRE, this is roughly equal to the cap rate for the property. The cost of equity includes a premium above the risk-free rate. That is, investors require a premium because they have no guarantee that they will earn a positive return. Accordingly, when evaluating equity vs debt, the greater the risk assumed by equity investors requires a higher return.

Key Differences in Debt vs Equity

The differences in debt vs equity financing help determine which is best for your purposes.

1) Taxes

The interest in CRE loans is tax-deductible, but equity isn’t deductible. Specifically, this reduces the after-tax cost of debt by an amount equal to your tax bracket. For instance, if your tax bracket is 20%, your after-tax cost of debt is only 80% of the before-tax figure.

For more information, you can download this Overview of the Tax Treatment of Corporate Debt and Equity from the Joint Committee on Taxation.

2) Ownership

Lenders are not owners and don’t have control over how you run a project. However, if you default on your loan, the lender can foreclose on the property, obtaining full control. Also, lenders might attach restrictive covenants to their loans that can constrain your freedom of action. For example, the lender might insist that you maintain a debt service coverage ratio of 1.25. Naturally, this might prevent you from taking on any additional debt. In contrast, equity investors are partners and often demand to participate in project decisions.

3) Repayment

You must repay loans but not equity. Sometimes, loans include prepayment penalties that charge extra fees if you pay off the loan before its term ends. Ideally, you should include prepayment penalties when you calculate your cost of debt, that is if you intend to prepay the loan. Remember, you can lose your property if you fail to repay your loan on time. Since equity belongs to you, there is nothing to repay.

4) Cost of Debt vs Equity

Generally, the cost of debt will be less than the cost of equity, especially after figuring in taxes. Fixed-rate debt will be cheaper than variable-rate debt when interest rates rise. Consequently, the reverse is true when interest rates fall. Furthermore, your creditworthiness can affect the interest rate you pay for the debt. The cost of capital is the weighted average of the costs of debt vs equity.

5) Approval

You must apply for a loan and then withstand the scrutiny of commercial underwriting. The lender evaluates your credit score, your business history, the value of the property and your personal guarantee. Inevitably, some commercial lending sources are hard to please, and they can take a long time to approve your loan. Naturally, using equity sidesteps all these problems.

6) Capital Gains

You earn capital gains when you sell your property for a profit. Specifically, you measure profit as the net proceeds from the property’s sale minus the property’s cost basis. Another important metric is the return on equity. Importantly, it’s a measure of how much profit you make as a percentage of the equity you invest.

Which Is Right for Me?

Almost all real estate deals involve both debt and equity financing. Naturally, lenders want to see borrowers invest equity and therefore share the risk. Truthfully, the real question is where you will obtain your debt financing.