The simplest solution is not always the best one. A complicated strategy to financing commercial real estate projects can actually be an advantage. In our real estate development company, we have found that adding complexity to the capital stack can help make your project more profitable and less risky for investors.
The standard capital stack, the framework that represents how a commercial real estate project is financed, is typically structured in two parts: 30% equity and 70% debt. It’s a straightforward, easy-to-digest formula; developers have to come up with 30% of the total project cost from investors, then cover the remaining 70% with a construction loan.
But this simplicity comes with high risk. On the debt side, 70% is considered a high-leverage deal. If the project goes south for any reason – a turn in the market or delays in construction or funding, for example – you are on the hook for a high proportion of debt to total cost. With 30% equity, you must also provide profitable returns to investors who financed 30% of the total project cost. Higher equity leads to lower returns for more investors. The most important priority for your investors is the intended rate of return. They only care how quickly they will get their money back and what their ROI will be.
To mitigate these issues, we believe you need to move away from the typical 30-70 capital stack and instead use what we call a “smart capital stack.” It requires more planning on the front end, but it ultimately produces higher returns and better security on commercial real estate deals.
What Is The Smart Capital Stack?
The smart capital stack is still composed of debt and equity, but the breakdown of each is more complex:
Debt
Instead of setting your construction loan at 70%, aim to develop a project where you don’t exceed 50% on leverage. This way, if you hit a recession, the market drops or the project encounters problems of its own, you have lower risk than the standard capital stack.
Equity
Reduce your equity from 30% to 20%. Again, the reasoning behind this move is that lower equity results in a higher return on investment because you are dividing the return among a smaller number of investors.
After securing 50% of financing through a construction loan and 20% through equity, you still have 30% of your project balance to cover. The challenge now is deciding which type of funding to secure. There are several options, but we have had success using investment through the EB-5 program, which is administered through U.S. Citizenship and Immigration Services (USCIS).
The EB-5 program allows foreign investors to gain permanent residency in the U.S. through a capital investment in a new commercial enterprise that meets certain criteria and will create at least 10 full-time positions. Many investors, lenders and real estate developers aren’t familiar with the intricacies of EB-5, and several high-profile fraud cases have damaged the program’s reputation in recent years. But it still remains an excellent financing option for commercial real estate projects, if you are willing to take the time to educate investors and meet the program’s strict requirements. New EB-5 regulations were put in place on November 21, changing the minimum investment amounts and other variables that make the use of this program even more challenging. However, we believe the EB5 market is now going to be better for those developers involved in well-structured smaller deals where the EB-5 portion is up to $20 million.
If you secure the remaining 30% of the project cost with EB-5 investment, you are fully funded – at least in theory. The problem is that in practice, EB-5 funding is slow money. It generally takes a long time to raise funds through the program, and once they are in place, you must go through a multistep process to withdraw the money.
Here’s where the smart capital stack gets a little more complicated. You won’t have access to EB-5 funds immediately, and waiting months or years for it will hurt your profitability. You need an alternative source of financing in the meantime, which you can achieve in two ways:
1. Apply for a higher construction loan on a temporary basis. Request a line of credit that has a minimum and maximum loan amount that will allow you to start drawing funds from the loan sooner than anticipated.
2. Raise small amounts of unsecured debt to bridge any remaining gaps.
Let’s take a closer look at the smart capital stack in action. Our company is completing a hotel construction project in Florida that used this exact model. The total project cost was $42 million, and we raised $7 million in equity from private investors and $16 million through EB-5 investors. The balance was $19 million, but we signed a construction loan with a minimum of $19 million and a maximum of $21 million. We also raised $2 million of unsecured debt as a safeguard. The lender saw that we were fully funded and allowed us to start drawing funds to start construction long before the EB-5 investment would be available.
The smart capital stack is much more complicated than the standard framework, but it allows you to make your project more profitable on a shorter timeline. You are able to raise less money and take on less debt, while minimizing risk and maximizing returns for investors.