Funding Real Estate Development Isn't as Simple as You Think

Whenever you see a new project being built in your neighborhood, there is typically a single real estate entrepreneur (usually known as a developer) that is credited as the owner. The developer garners the majority of the public attention, and receives both the accolades and criticism that come with the project. What most people don't know is that this developer has, in fact, only invested a small fraction of the total money needed for the project.

Funding a Real Estate Deal: Debt and Equity

In almost all real estate deals, both debt and equity play enormous roles. Most projects require some level of traditional bank debt. Whether the project costs $1 million, $10 million, or $100 million, a bank is normally involved, providing 60%-80% of the total capital.

So for a $10 million property, a bank might lend $7 million (70%) of the capital, leaving $3 million of equity required. The bank will charge an annual interest rate on the loan they make but will not receive any actual ownership in the property.

So where does the $3 million of equity come from? The developer will then raise 80%-95% of the remaining capital from investors. So in the example above where the developer raised $7 million in debt, he might then raise $2.7 million (90%) of equity from investors and invest $300,000 (10%) himself.

Developer:   $300,000 (3%)
Investors:  $2,700,000 (27%)
Bank:         $7,000,000 (70%)
Total:      $10,000,000

While 3% may not sound like much, $300,000 is a fair amount of money for a single individual or small team to have available as cash. This becomes even truer when you realize that many real estate projects are much larger than $10 million and most real estate developers usually have several projects going at any one time. In short, it adds up.

If you are interested in more details, here is an example of real estate development financials for a property in Washington, DC.

These financial breakdowns also raise a question: if the real estate developer is only providing a fraction of the equity, who is investing the remaining 80%-90%?

Who Really Owns Local Real Estate?

The fact that developers have their names attached to projects has created a misconception that these developers own and control most local real estate. On the contrary, the vast majority of equity is coming from outside investors: high net worth individuals or large investment funds. This outside source of capital is in fact the major driver of how a project gets developed – ultimately these outside investors are the majority owner of the property.

In today's world, raising money from individuals is very inefficient and time-intensive and as a result, most developers choose to raise money from private equity funds.

When a private equity fund invests in a project, it typically holds a super-majority of the equity and therefore keeps the governance rights over major decisions and ultimately has the power. This can cause large problems for the developer if he does not stick closely to the agreed-upon business plan. When push comes to shove, the investment fund can even take over the property and kick out the developer. These realities have resulted in private equity funds becoming the primary driver of real estate development.

There are many consequences of this major corporate ownership, most notably that a fund's primary goal is to drive returns for their investors — not to focus on developing the right project for a neighborhood.

To learn more, check out the investments and developers on Fundrise.

If you're not investing in real estate...

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.