What's the best capital structure for your real estate development project?

1 What is capital structure?

Capital structure is the mix of debt and equity that you use to finance your real estate development project. Debt is money that you borrow from banks, private lenders, or bondholders, and that you have to repay with interest. Equity is money that you raise from investors, partners, or yourself, and that gives you ownership and control of the project. The proportion of debt and equity in your capital structure affects your project's profitability, risk, and flexibility.

2 Why does capital structure matter?

Capital structure matters because it influences your project's return on investment (ROI), cash flow, and risk profile. Generally, debt is cheaper than equity, because lenders have a fixed claim on your project's income and assets, and they are paid before equity holders. However, debt also increases your financial risk, because you have to meet your debt obligations regardless of your project's performance. Equity is more expensive than debt, because equity holders have a residual claim on your project's income and assets, and they expect a higher return for taking more risk. However, equity also gives you more flexibility, because you don't have to make fixed payments or follow strict covenants.

3 How to choose your capital structure?

Choosing the right capital structure for your project is a complex decision that depends on its characteristics, objectives, and market conditions. Generally speaking, debt can be used to leverage your equity and increase ROI, but only up to a point where you can service it comfortably and maintain a healthy debt-to-equity ratio. Equity, meanwhile, can reduce financial risk and enhance flexibility, though only to the extent that you can offer attractive returns to investors and retain control. You should also consider the availability, cost, and terms of different sources of debt and equity, selecting those that best match your project's timeline, cash flow, and risk profile. Finally, it's important to monitor your capital structure throughout the life cycle of the project and adjust it as needed in response to changes in performance, value, and market conditions.

4 What are some common types of debt and equity?

When financing a real estate development project, there are a variety of debt and equity options available. Senior debt is the most senior and secured form of debt, usually provided by banks or institutional lenders, with the lowest interest rate and highest priority in repayment. Mezzanine debt is a subordinate and unsecured form of debt, with a higher interest rate and lower priority in repayment, but also more flexibility and less covenants. It may also include an equity kicker that gives the lender a share of the project's upside. Preferred equity is a hybrid form of equity, with a fixed or variable dividend rate and seniority over common equity in repayment, but limited or no voting rights and control. It may also have a participation feature that gives the investor a share of the project's upside. Common equity is the most junior and risky form of equity, with no fixed or guaranteed return and full voting rights, but it also bears the most risk and reward of the project's outcome.

5 How to optimize your capital structure?

Optimizing your capital structure means finding the optimal balance of debt and equity that maximizes your project's value and minimizes your project's cost of capital. To do this, you need to assess the feasibility and profitability of your project, evaluate its risk and uncertainty, forecast its cash flow and timing, and estimate its value and growth. Furthermore, you must determine how much debt and equity you need to finance your project, match them with your obligations and expectations, capture the appropriate share of your project's upside and downside, and create value for your debt and equity holders.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?