Commercial real estate deals are often very expensive propositions and therefore require a substantial amount of outside financing. This outside financing comes in two forms: debt and equity. Debt financing is preferable as it is widely considered to be “less costly” than equity financing. However, it is much harder to obtain and requires collateral. As a result, a combination of the two is called a capital stack and is the most common financing used. Let’s take a look at how this capital stack is composed…
The bottom of the stock is often composed of long-term debt. Typically, around 70% of the purchase price can be financed via a permanent loan from a bank, conduit or life insurance company and will have the lowest interest rate of out of the stack. The next portion – usually 10% of the purchase price – is composed of mezzanine (or second) loans. These are funded by different lenders over a shorter term of five years or less with moderately higher interest rates than the permanent loan. The next part – usually around 15% – is financed by a joint venture partner that takes an equity stake in the deal. These partners charge the highest interest rate of the stock because they are often looking for an exit in five to ten years. And finally, the remaining 5% of the deal is typically the equity that the buyer brings to the table.
Experienced mortgage brokers can help you find the two types of loans, but finding investors is another story. Typically, this is the hardest part of this process as few are willing to risk their money in a deal without a large payoff. The most common way to find these investors is to contact a broker who will phone his list of high net worth individuals and locate some investors. Another way is to contact your local accountants and ask if any of their clients are looking for tax write-offs. And finally, another great way to find partners in the project is to simply ask the old owners if they are interested in an equity stake in the new project. Or, if you are simply purchasing land, ask if the land owners would be interested.
Determining if the financing is sufficient is simply a matter of basic math. Calculate the rent that you are able to charge and subtract expenses in order to determine the net operating income (NOI) of the property. Then, subtract out your mortgage payments and dividend payments to equity investors. The remainder is your personal return on investment. Figuring out the value of your investment is simply a matter of dividing the property’s value by the cap rate (industry average in your area) and subtracting out other equity stakes. Combined, these two returns plus your tax write-offs are what makes up your commercial real estate investment’s value. If this is high enough to justify, the project is a go!