Real Estate Finance

What is the capital stack?

The totality of capital invested in a project, ranked by risk—most risky at the top, least risky at the bottom.

Typical capital stack percentages?

Equity (20%), Public Finance (15%), Mezzanine Debt (10%), Mortgage Debt (55%).

What are the two main types of real estate capital?

Equity (ownership) and Debt (loans).

What defines equity capital?

Capital exchanged for ownership with no guarantee of return.

Who commonly provides equity?

Developers, friends/family, private equity, REITs, institutional investors.

What does a debt provider want?

Their money back within a specified period plus interest.

What is the simplest form of debt in real estate?

Mortgage

How does debt reduce risk for lenders?

Through collateral, contract terms, and lender rules

Traditional Intermediaries

banks, credit unions, pension funds, insurance companies, mutual funds, REITs

Pre Development (highest risk)

Financed by 100% equity

Construction

30% equity, 70% construction loan (short-term debt)

post development

20% equity, 80% permanent mortgage (long-term loan after paying off construction loan)

What are the two parts of a mortgage?

An IOU (loan agreement) and a collateral document.

What is collateral?

Assets pledged to secure a loan.

What happens when a loan becomes nonperforming?

The lender may foreclose after a grace period.

What is foreclosure?

The lender takes and sells collateral to recover the loan balance.

What is excess collateral?

Collateral value exceeding the loan amount to protect lenders

What defines a rectangular mortgage?

Fixed term, fixed interest rate, fixed payment, full amortization.

Principal declines steadily to zero by loan maturity

What are the two main lender rules?

Loan-to-Value (LTV) and Debt Service Coverage Ratio (DSCR).

What is Loan-to-Value (LTV)?

Loan ÷ Property Value

What does an 80% LTV mean

The lender finances up to 80% of the property value

What is Debt Service Coverage Ratio (DSCR)

NOI ÷ Debt Service

What does a DSCR of 1.25 mean?

NOI must be 25% higher than debt payments.

How is Net Operating Income (NOI) calculated?

Revenue − Operating Expenses

How is property value calculated?

Value = NOI ÷ Cap Rate

Relationship between cap rate and value?

Higher cap rate → lower value; lower cap rate → higher value

What does a cap rate represent?

Expected return and risk of an income-producing property

Investment/Commercial RE

No debt is assumed

CAP Rate through history of sales NOI/Purchase Price x 100

Hospitality RE

Always assume there is debt

CAP Rate based on cost of capital

equity % x rate of return %

What does a higher cap rate indicate?

Higher risk & higher potential return

Second Mortgage

Loan agreement with a collateral document whereby the lenders access to the collateral is subordinated to other collateral agreements

Key traits of construction loans?

Short-term, interest-only, recourse, paid off by mortgage

Key traits of mortgage loans?

Long-term, amortizing, often non-recourse.

What is subordinated debt?

Debt repaid after senior lenders (first position) in foreclosure. Riskier due to lower priority in repayment

Subordinated debt usually requires much higher interest rates & shorter terms

What is mezzanine lending?

High-risk, high-interest, short-term (1-5 years) capital filling financing & capital gaps

subordinated loan

high return investors (PE funds)

What does leverage mean?

Using debt to finance a project.

main benefit is a higher return on equity

Main risk is increased financial risk & cash flow pressure

What is free cash flow?

NOI before debt and taxes.

used for evaluation

What is leveraged free cash flow?

NOI minus debt payments

balance distributed to equity providers

Net Present Value (NPV)

Time value of money- discounted cash flow

If NPV at the end of a specified period is greater than the cost of the original investment it’s a good deal. Reverse is also true

What is Return on Equity ROR?

Annual NOI ÷ Equity invested

Measures NOI against equity investment

Annual investment

What is Return on Equity ROE?

Getting back equity in addition to ROR

Over time or at sale (specified in partnership agreement)

What does IRR measure?

Total return over the holding period, including sale.

Good ranges: 6-11% unlevered, 7-20% levered

What is an equity multiple?

Measures all returns (inflows & outflows) against the initial equity put into the project

inflows: sum of annual NOIs + capital gains

outflows: the equity invested

good equity multiples: 1.5x-3.0x

Most common real estate ownership structure?

Limited Liability Company (LLC).

Benefit is limited liability with pass-through taxation

Limited Partnership

A GP manages; LPs invest passively

What is an equity waterfall?

How cash flow is distributed between GP and LPs.

What is a promote?

Extra share of profits awarded to GP after hurdle rate.

What is a 1031 exchange?

A tax deferral strategy allowing reinvestment without capital gains tax.

Key rule is to exchange a like-kind real estate within 180 days.

Recourse

Personal guarantee until loan is repaid

typical for construction loan

Non-Recourse

No personal guarantee is required

project itself is the collateral & guarantee

typical for mortgage on finished and/or existing project