Raising money for property development is often the biggest obstacle for aspiring real estate moguls. After all, not many people have the capital to fund an entire project when they’re starting out. And even seasoned developers may need an influx of cash to capture an opportunity or protect against risk.
Don’t let a lack of funding stop you from building a successful real estate business. There are more ways to finance investment property than you may realize.
HOW TO FINANCE A PROPERTY DEVELOPMENT PROJECT
First, let’s talk about the two types of real estate financing – debt and equity.
Debt financing is a secured or unsecured loan, which makes it a bigger risk. If the real estate development doesn’t pan out, you’re still on the hook for the loan balance – and in some cases, interest rates can be steep.
Equity financing involves selling a share of the company’s equity in exchange for capital. While you don’t have to pay back the investment, this means you lose some control over how the business is run. Plus, the investor will receive a portion of the profits if you sell your company.
Depending on your long-term goals and financial needs, you may already know which one you prefer. Finance for real estate development isn’t just about getting the money – it must fit within the vision you have for your business.
Let’s walk through the sources of both debt and equity financing, so you can better understand the pros and cons of working with each potential partner.
1. Conventional Lenders
Commercial banks, credit unions, and mortgage companies offer a broad range of real estate loans, each with its own set of requirements and terms. While they’ll vary by lender, we’ve pointed out some of the key differences between each loan type.
This type of loan works like a residential mortgage. You put a certain percentage down and make payments over an agreed-upon time period. Commercial mortgage loans offer both fixed and variable rates which depend on the borrower’s credit score and business stability.
While commercial mortgages are widely available, they also have more stringent requirements and the approval process can take longer. In addition, they require a down payment of no less than 20% and terms are often in the range of 5-20 years, making the monthly payments sizable.
Balloon or Interest-Only Commercial Mortgage
This is another version of the commercial mortgage. You can secure lower monthly payments by agreeing to a large payment at the end of the loan term. But you’ll need a solid plan for paying it off. For example, if you intend to sell the property after construction or renovations, you could earmark some of the profit for this final loan payment.
This is a short-term mortgage that helps the borrower “bridge” the gap between financing options. For example, you might pay off an expiring term balloon loan to position the property for a more favorable longer-term loan. In many cases, developers use bridge loans for renovations or construction before a comprehensive refinance.
The borrower must either pay the loan in full at the end of the term or roll it into a different financing program. Business owners need a credit score of at least 650 to qualify and must be able to cover a 10% to 20% down payment. These loans are typically 6 to 12 months with higher interest rates than that of a traditional mortgage, but lower than a hard money loan, which we’ll describe in a moment.
A conduit loan, also called a commercial mortgage-backed securities (CMBS) loan, may be more appealing for real estate developers since its standards aren’t as strict compared to a traditional loan and you’ll often find the interest rates to be lower. Another benefit is that if you decide to sell the property, the buyer can take over your loan.
This type of loan is sold and packaged along with other commercial mortgage loans into a trust called a Real Estate Mortgage Investment Conduit (REMIC). It’s then turned into bonds, rated, and sold on the secondary mortgage market. After the bond is sold, the lender is repaid and the administration of the loan shifts to a service provider. Like a conventional balloon mortgage, conduit loans have a large payment due at the end of the loan’s term.
Drawbacks of a conduit loan include less flexibility in negotiating loan terms or changing them later. In addition, since the loan is part of a trust, there are usually prepayment penalties. You may also have to go through a process called defeasance, where you replace the property with another form of collateral.
Conventional lenders offer a broad range of real estate loans, each with their own set of requirements and terms.
2. Hard Money Lenders
Similar to a bridge loan, hard money loans help with a short-term cash need. However, you wouldn’t be borrowing from a traditional financial institution. Hard money lenders are individuals or companies with a license to lend to real estate investors. They’re willing to take risks based on the value of the commercial property itself, not the credit rating of the borrower.
While this makes their requirements less rigid and speeds up the approval process, it comes at a price. Interest rates can be as high as 10% to 18%. You’ll also pay higher fees, sometimes four times what you’d pay for a conventional loan.
3. Small Business Administration-Backed Lenders
The US Small Business Administration (SBA) backs several loan programs of interest for real estate investors. While there’s a bit of time and paperwork involved, your efforts could be rewarded by lower interest rates and extended repayment terms.
Most importantly, you first must apply for a conventional bank loan – even if you know you’ll be rejected. Requirements also include a credit score of at least 680, at least two years of business experience, and a background free of recent bankruptcies, foreclosures, or tax liens.
Here are the SBA loan programs, commonly referred to as 7(a), that are most appropriate for real estate development. If you’re in the military or a veteran, you may qualify for reduced fees.
- Standard 7(a) – Borrow up to $5 million
- SBA 7(a) Small Loan – Borrow up to $350,000
- SBA Express Loan – Borrow up to $350,000, with a response in 36 hours
There’s also the SBA 504 Loan. This is for small businesses planning to buy or build owner-occupied commercial real estate. To qualify, your business must physically occupy at least 51% of the commercial structure. It also introduces a partnership with a local community development corporation (CDC). Like the SBA 7(a) loans, you’ll need a credit score of 680 or higher. But you must also meet the local CDC’s job creation and public policy goals.
4. Private Lenders
Private lenders aren’t licensed to lend money, but they have access to capital and are looking for strong financial returns. This could be anyone who’s willing to loan you money for your real estate enterprise. You can find private lenders through networking or crowdfunding, which we’ll describe in a moment. In general, their requirements are more relaxed. However, the loan terms are usually shorter and interest rates will be high – often around 12% to 15%.
5. Angel Investors
An angel investor is someone who invests in a new business venture by providing capital in exchange for equity in the company. They’re typically wealthy individuals willing to take risks for greater returns. Angel investors may provide a one-time investment or ongoing payments to support the company through its early-growth stages. Angel investors invest individually, through online angel platforms, or networks to pool capital together.
Before considering an angel investment, be sure to have a comprehensive business plan in place. You’ll need this to pitch your project’s viability and potential success. Equally important, ask what the investor can bring to the deal besides funding. You want someone who has expertise in real estate development, access to suppliers, or valuable connections. And finally, make sure you’re in agreement about how to operate your business.
6. Silent Partners
Silent partners are similar to angel investors in that they provide funding in exchange for equity in your company. However, as the name implies, they have no active involvement in the way your business runs. Depending on their stake, they receive a percentage of the net profits and a portion of the profit if you sell the company. To engage a silent partner, you’ll need to present a strong case that your real estate venture will succeed since they won’t have the ability to influence business operations.
7. Venture Capital Firms
Venture capital firms are another source of equity financing. These are private entities that hold investors’ money in a single fund. Venture capitalists seek out large projects on the cusp of major growth that they can steer toward success based on their industry knowledge. Often, they’re looking for a big pay-out in the form of an acquisition or stock market launch. If this isn’t your goal, other forms of equity financing like angel investors or silent partners might be a better fit.
8. Crowdfunding Platforms
Among development funding options, crowdfunding is a relatively new strategy for real estate developers. These online platforms allow you to source your capital from numerous smaller investors, expanding your network beyond what was ever possible. Popular platforms include RealtyShares, RealtyMogul, iFunding, and Patch of Land.
Keep in mind that crowdfunding platforms perform due diligence and credit checks just like traditional banks, but the process is more transparent and efficient. To participate in a crowdfunding platform, you need a clear business plan in place and solid financial projections. You should also be prepared to answer questions from potential investors.
Let’s take a closer look at the two types of crowdfunding.
In equity crowdfunding, many people invest to purchase an asset. A single-purpose entity (SPE) is created to facilitate this arrangement. In exchange for their contribution, investors own shares in the SPE. There’s usually an operating agreement that defines each investor’s rights and responsibilities and describes their share of the profits. For example, they may receive a percentage of the net operating income from rent payments. Investors also typically share a percentage of the profits if you sell the asset. The big advantage is – although you’re sharing equity, there’s not a significant loss of management control.
Debt crowdfunding is when multiple people invest in a mortgage loan associated with a particular property. As the borrower repays the loan, the investor receives a share of the interest based on how much they contributed. The loan is secured by the property itself. Some platforms will front the money to the developer and then collect the capital with money from the investors. Others simply allow developers to list their projects and don’t provide funding until there are enough investors. Although loans are typically short-term, online platforms may have lower overhead compared to a bank, which can translate to fewer fees and lower interest rates.
In equity crowdfunding, many people invest to purchase an asset. In debt crowdfunding, multiple people invest in a mortgage loan associated with a particular property.
Need Help Exploring Your Real Estate Development Funding Options?
Hopefully, this article has helped you understand how to finance a property development project. If you have more questions or want some expert advice to evaluate your options, contact Insight Property Advisors. Leveraging our experience with development projects and access to a network of lenders, our team can identify sources for short- and long-term financing as well as interim loans. We can also advise on the formation of partnerships and other corporate structures.