In the capital stack, having some of your own money, or at least money you can control, the equity, is critical. When you’re looking for land, when you’re planning a project, when you want to put land under contract and need to hire a team of consultants to understand exactly what you’ve got, you’ll need some cash to spend. It’s a given that the first dollars you’ll spend will be equity, creating value and an ownership position in the project you want to develop. After that, most real estate development projects will seek debt financing.
Lenders need to loan money. It’s what they do to earn revenue. Banks are the obvious choice of funding for good reason. Their mission is to loan money. Think back to how George Bailey explained it in It’s a Wonderful Life to his fellow citizens of Bedford Falls. The money doesn’t stay in the bank, it’s loaned to help the local businesses and property owners in the community. Banks lend, but they’re cautious and risk averse. They only need to make a minimal return on their debt investments, but they desperately want to avoid losing a penny.
If you can get through the bank hurdles, the money is cheap, and the funding can be readily available. But it’s not easy or quick, generally, to establish a lending relationship with a bank. Because real estate is risky, they want to be in a position so that even if the worst happens, they can recover their funds.
You’ll need an environmental study to prove there’s no nuclear waste or major earthquake faults on the site. You’ll need a very detailed land survey so there’s absolute clarity about what is being offered as collateral. You’ll need an appraisal that validates the value of the land. You’ll need a nice sales piece explaining the market and why your project is a can’t lose proposition.
You’ll need attorneys to review the documents the bank wants you to execute. You’ll need proof from all the local government agencies proving you’re allowed to do the project and that they will provide services. You’ll need pretty pictures and maps. You might need to offer up everything else you own as a guarantee. And you’ll have to pay for all of this, including for the bank’s attorneys who draft the documents with a bias against you, to get it done.
Any significant business decisions you make about the project design, construction, and sales will be subject to approval by the bank. But the truth is, it’s worth it for the prime rate money available to pay for 70% to 80% of your total project costs, including the land acquisition.
There are other options. The hard money guys who are happy if you fail so they can take the project. The mezzanine debt lenders who may take your company if you fail. So, banks, despite the time and complexity they bring to the process, are a critical source of funding for almost every real estate development you see. Also, equity returns can be increased on a percentage basis with leverage. I’ll break the concept down and demonstrate that simply in a future blog post.
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