Equity vs. Debt?
For those not familiar with the finance side of housing projects, today will be a brief explanation of the two basic forms of financing – equity and debt.
First, let’s start with the debt side or the construction loan. Large and small banks will offer construction loans with interest rates much less than the cost of equity. The loans could be for 70% of the total project costs, and in some cases I have heard of 70% “loan-to-value” which generally means relative to total project revenue. This loan percentage can probably vary from bank to bank, and from borrower to borrower. The interest rate on these construction loans probably range from 5% – 7% (annual rate), and the borrower will pay 1 – 2 points on the total loan amount. The overall cost for this construction loan is inexpensive compared to the equity, but that is because the construction lender gets first priority on repayment. The loan has less risk than the equity capital.
Now, let’s get to the equity side of the financing. If the construction lender puts up 70% of the costs, that means that the project needs 30% in equity capital to complete the financing. In some cases, the homebuilder will internally fund this equity requirement. But in many cases, an equity investor will provide most of this equity capital, but at a much more expensive rate. A very typical structure is that the equity investor will put up 90% of the equity, earn a 10% – 12% preferred return on outstanding capital, and then split profits with the homebuilder on a 50/50 basis. At the end of the day, the equity investor wants to earn at least a 30% annualized return on his capital, which comes from the preferred return and 50% of the profits. The high cost of equity is due to risk – the construction lender gets paid back first. If the project goes sideways, the risk to an equity investor is the possibility of no return of its investment and loss of profits.
As you can see, a low-cost construction loan is really necessary to make a housing project work. The larger public builders have large lines of credit from major banks, probably at lower rates and no requirement of equity as these large builders have substantial balance sheets that provide them with significant financing advantages. Small and medium sized builders will need to provide the equity, which raises the overall financing costs for a project. But the construction loan is still needed to have reasonable financing costs and be competitive in the housing market.
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