3.B2. Debt vs. Equity Pt. 1
Structuring a Deal: Understanding Debt and Equity
Definitions of Debt and Equity
- The speaker defines debt as borrowing money at a known rate of return, while equity involves sharing in both the upside and downside of a project based on its performance.
Types of Debt
Bank or Institutional Debt
- The primary sources of debt include bank or institutional debt (e.g., commercial banks, credit unions) and private debt.
- Commercial banks are preferred for ground-up development deals due to their market knowledge and favorable lending terms.
Importance of Experience
- Lenders assess not only the project but also the operator's experience; having a strong resume is crucial for securing loans.
- Partnering with an experienced contractor can enhance credibility with lenders, especially if they have prior relationships with the bank.
Hard Money Lenders
- Hard money lenders are considered risky; they may be necessary when other options are unavailable but can lead to high costs.
- National hard money lenders are more suitable for large projects compared to local lenders who typically avoid construction loans.
Agency Debt Overview
Benefits of Agency Debt
- Agency debt is commonly used by large apartment syndicators; it does not require personal guarantees unlike traditional bank loans.
- A significant advantage includes 30-year amortization, which is rare in commercial financing.
Limitations of Agency Debt
- Agency debt has strict requirements regarding loan-to-value ratios, particularly in smaller markets like Bryan, Texas.
- It is applicable only after a project is built and stabilized; agency lenders prefer experienced operators managing properties.
Private Debt Insights
Characteristics of Private Debt
Understanding Private Money Lending in Real Estate
The Role of Private Money Lenders
- Private money lenders often pull investor funds to lend on their behalf, providing flexible terms and competitive interest rates.
- In development deals, private money lenders need significant liquidity as they may serve as primary lenders alongside bank debt.
- Mixing private and bank debt can be challenging; private lenders must be willing to take a second lien position behind the bank.
Seller Financing as an Alternative
- Seller financing is favored when purchasing properties intended for long-term hold while awaiting necessary approvals for development.
- Ideal scenarios involve acquiring properties with existing rental houses that cover the note during the holding period, minimizing financial loss.
- Once construction loans are secured, seller financing notes can typically be paid off or converted into costs within the bank loan.
Challenges with Seller Financing
- Seller financing may not suit development loans due to land costs being a small fraction of total project expenses.
- Often, sellers are not sophisticated enough to agree to remain in a deal if it requires taking a second lien position behind a bank loan.