Investment grade commercial properties are rarely purchased by an individual investor. Instead, they are usually purchased in a structure where one individual (or company) takes the lead to assemble capital from a group of investors and uses it to close the transaction. In short, this structure is called a syndication.
In this article, we are going to discuss how capital is typically raised in commercial real estate investing. In doing so, we will discuss common sources of capital, how it is used, how it is organized, and how it is managed. By the end, investors will have a deeper understanding of the capital raising process and will be able to utilize it in their individual investment workflows.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
Investment Capital Definition – Understanding The Capital Stack
The term ‘“capital stack” is commonly used by commercial real estate investors to refer to the sources of financing used to finance a real estate deal. While the specifics can become complex, there are two buckets in the typical capital stack, debt and equity.
Debt typically makes up the largest portion of the capital stack, usually somewhere in the range of 50% – 80% of the purchase price depending on the specifics of the deal. Debt is typically sourced from banks, hedge funds, insurance companies, government sponsored entities (FNMA), or pension funds. “Senior” debt holders are secured by a first lien mortgage on the property, which puts them first in line for repayment from property cash flows. In a typical structure, they are repaid monthly with some combination of principal and interest. The terms of the debt – like interest rate, upfront fees, etc – are dictated by the lender’s risk appetite and the risk profile of the borrower (credit score, debt service coverage, etc.).
Equity is the money that makes up the difference between the debt and the purchase price. So, for example, if a property had a purchase price of $1,000,000 and the buyer was able to get $750,000 in debt, they would have to come up with $250,000 in equity. So, when investors talk about having to “raise equity” they mean they have to find the money to fill the equity portion of the capital stack. If they have a well heeled equity partner, the money may just come from one person. For larger deals, it is more likely they will have to find dozens or even hundreds of potential investors, which can be time consuming.
Ways To Raise Capital for Commercial Real Estate Investing
Consider the example above, but scale it to an investment grade commercial property. Suppose an investor finds a retail center with a purchase price of $20,000,000. Through existing bank relationships, they are able to get debt at 75% loan to value or $15,000,000. This means they have to raise the other $5,000,000 from investors. There are a number of ways this could potentially be accomplished.
Loans
Most commercial real estate is purchased with a combination of debt and equity financing. Real estate loans can take on many shapes and sizes. A loan issued to buy a property could range from a simple bank loan to a more complex mezzanine debt offering. Let’s look at a few of the most common types:
Bank loans are issued to real estate investors by banks and other financial institutions. They can vary in term and usually have to go through the bank’s underwriting process. This means the bank reviews the investor’s financial position as well as the prospects for the property being acquired. Interest rates on bank loans are competitive and can be found simply by consulting with a loan officer at the bank.
Private loans are issued by individuals or companies that are not primarily in the business of lending money. These loans often come about through personal relationships or situations where an individual is looking to lend money to earn a return on their savings. Private loans are negotiated directly between the borrower and lender, and the terms can vary widely depending on the objectives of each party.
Hard money loans are issued by lenders who specialize in lending to real estate investors, especially those looking to pursue value-add strategies. Hard money lenders loan money based on the prospects of the deal, rather than the financial strength of the borrower. These loans often have shorter terms than bank loans or private loans, and almost always have the highest interest rates of the three. Borrowers usually try to refinance to a bank loan as soon as possible.
Partnerships
For smaller deals or transactions where one investor has a significant amount of capital, one common investment strategy is to form a partnership.
A partnership is a deal structure that involves two or more individuals, each of whom contribute their prorate share of the required equity. In the example above, say there were 10 partners and they each provided $500,000.
In a partnership, each individual is entitled to their pro rata share of the income and profits produced by the property. But, it also goes both ways. If the property needs a major repair or if the rent is not enough to support the operating expenses, the partners may be subject to a “capital call” which means they have to put in their pro rata share of the money needed to keep the property running. Ideally, this never happens, but it is definitely a risk to consider.
The major benefit of a partnership is that, in return for investing their own money, each partner has direct ownership of the property and direct say in the decisions needed to manage it. In addition, the partnership structure avoids the double taxation associated with a corporation.
The major downside of a partnership is it can become very complex if just one partner is not able to fulfill their financial obligations or is particularly opposed to a major decision. For example, suppose the property needs a new roof and there is not enough money in the operational reserves to pay for it. Each partner needs to chip in $10,000, but one doesn’t have it. The roof still has to be replaced so the other partners have to make up the difference, which can cause disagreements and confusion among the partnership group.
Crowdfunding
There are a number of companies like Fundrise or Crowdstreet who provide a platform for individuals to advertise their investment opportunities to a built in audience of investors looking to crowdfund commercial real estate deals. Each individual purchases some number of shares in the LLC, which in turn owns the property. Each investor is entitled to their pro rata share of income and profits.
The benefit of this approach is that deals can get funded faster and easier through an in-place network of individuals who are actively looking to fund deals. This can be a major asset when trying to get a deal closed under tight timelines.
The downside of this approach is that these platforms charge fees, which cut into the amount of equity raised. In addition, it is a competitive space where deals have to compete with each other for funding so it can be difficult to stand out.
Self-Directed IRAs
This is not a fund raising method per-se, but it can be a source of equity capital.
An Individual Retirement Account, IRA for short, is a specialized type of investment account that allows individuals to defer income taxes on contributions to the account as long the funds remain in the account until the owner reaches a certain age. In a self-directed IRA, the account holder has a wide degree of latitude regarding the assets they are able to invest in – including commercial real estate deals.
The benefit of working with investors to tap their self-directed IRAs is this may provide access to more capital than is typically held in traditionally taxable accounts. In addition, it may attract more investors because this is a more tax efficient way to invest.
The downside is there may be some additional educational effort required to alert potential investors to this option. In addition, there may be some additional administrative work required to ensure the investment is processed without incurring a tax liability in the process.
Syndication
Finally, the last and most common option is known as a syndication.
A syndication is a two tiered structure that allows investors to purchase a fractional share of a real estate project without incurring the hassle of actually managing the property. The syndication is organized by a deal leader, usually referred to as the “General Partner” and they do all of the hard work of finding, financing, and managing the property. They also are responsible for raising the equity needed to close the purchase.
The other party in the deal is known as the Limited Partners and they are the individual investors who contribute capital to the deal. They could be new investors or they could be existing investors in other deals also offered by the General Partner. These individuals contribute their own capital and receive passive income from the property.
For deal leaders, the benefit of this approach is it can be used on a large scale, meaning it can be an effective way to raise a lot of other people’s money. In addition, it allows a real estate business to scale their investment portfolio into a large company that produces a significant amount of cash flow. For investors, the benefit of this approach is they receive all the benefits of commercial property ownership without having to do the work of managing the property. In addition, they get to leverage the expertise and resources of a professional real estate firm when it comes to finding, financing, and managing the property.
For deal leaders, the downside of this approach is it can be administratively burdensome and very competitive to complete this type of fundraising in a very competitive space. Further, the target audience is fairly limited because securities laws dictate they can only work with individuals who meet certain income and or net worth thresholds. For investors, the downside of this approach is the deal leaders often charge fees, which can cut into profits. In addition, the selection of the deal leader is critical to maximizing the chances for a positive return. So, it is important to only work with those that have a strong track record of delivering returns.
Raising Capital for Residential vs Commercial Properties
There are four notable differences to consider when raising capital for residential properties versus commercial properties.
The first is obvious. Residential capital is raised to purchase residential properties, which are defined as properties designated for living that have less than 4 units. So, this would be single family homes, duplexes, and triplexes. Commercial capital is raised for commercial properties, which are those with a business use. In the case of multifamily properties, those with more than four units are considered to be a business for lending purposes.
The second is flexibility. On the debt side, residential loan programs are fairly strict. Lenders must comply with a certain set of criteria to ensure their loans are backed by specific government entities (most notable FNMA). If lenders go outside this criteria, they usually turn into portfolio loans which cannot be sold into the secondary market. Usually these are hard money loans (from hard money lenders), private money loans (from private money lenders), or some other source of private capital. On the other hand, commercial properties come in all shapes, sizes, and types. Therefore, the loan programs that support them must have more flexibility to support the different types of business plans put forth by potential borrowers. For example, one individual may need a 5 year loan, while another needs a 10 year loan.
The third thing to consider is the cost. As a general rule, residential loans are far less expensive to originate due to their relatively smaller loan amounts and properties. On the other hand, the fees alone for a large commercial loan can run into the tens of thousands. In a very simple example, an appraisal for a typical residential property is usually in the $300 – $500 range. An appraisal for a large, complex, commercial property can run well into the thousands.
On the equity side, the fourth major difference is simply the amount of money that needs to be raised. Because commercial properties are so much more expensive than residential investment properties, much more capital must be raised to purchase them.
Raising Capital in Private Equity Real Estate Investing
Every private equity deal is unique, but they typically use a syndicated structure to raise capital from investors who meet the minimum income and net worth requirements.
In a typical deal, the private equity firm acts as the General Partner. They are real estate professionals who utilize their expertise and resources to find suitable investment properties and arrange the debt (bank loans) financing for them. They also handle potential renovations, leasing, and other property management activities. They may also contribute some of their own capital as equity in a deal to instill a sense of confidence in investors that they believe in the deal.
The private equity firm is also responsible for building relationships with a network of private investors to source the remainder of the equity capital/down payment needed to get the deal closed. This money comes from “Accredited Investors” who want to allocate money to the transaction. In return for their investment, individuals earn their proportionate share of the rental income and profits produced by the underlying property or portfolio of properties.
A private structure is usually appealing to those individuals who want to invest in the real estate market, but do not have time or expertise to find and manage a property. These types of deals are very common in the real estate industry and can be a great way for individuals to own a fractional share of an institutional quality asset.
Summary of Raising Capital for Real Estate Investing
The term “capital stack” refers to the collection of capital used to finance the purchase of a property. At a high level, it contains two types of capital, debt and equity.
Debt is usually the largest portion of the stack and can make up 50% – 80% of the property’s purchase price. Most commonly, it comes from banks, private lenders, or peer-to-peer lending networks. Debt holders are secured by a lien on the property that gives them foreclosure rights and entitles them to a first claim on the cash flow it produces.
Equity is the capital that makes up the difference between the purchase price and the amount of approved debt. Typically these are the funds that need to be “raised” to complete the purchase of the deal and it usually comes from investors.
Raising capital for real estate investments can be done using a number of different strategies including partnerships, joint ventures, real estate crowdfunding, and syndications.
Private equity deals are usually structured as syndications where the firm acts as the General Partner who is responsible for finding, financing, and managing properties. Individual investors act as Limited Partners and they contribute capital to the deal in exchange for a share of the cash flow produced by the underlying property. This may be an appealing structure for those who want exposure to real estate, but don’t want to put forth the effort to find and manage properties.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
