Just Where Do Developers Find The Equity For Their Projects?

In commercial lending it is more or less customary that a developer has to contribute equity equal to 20% of the total cost of a project.  Suppose a developer wants to put up a $10 million office building.  It is normal that the financial institution making the construction loan would require that the developer contribute a minimum of 20% of the total cost of the project.  In this case the total dollar amount required from the developer would be $2,000,000.

Two million dollars is a lot of “moola” and there are not too many developers that have an extra $2 million just lying around like spare change on the top of their dressers at home.  So, where does your typical developer get this kind of equity money?  It goes without saying that all commercial lenders want to be able to get their money back in case of default.  Commercial lenders can help the developer with creative financing.

One way if for the developer to have the $2 million is equity in the land.  He may have bought the land in an outlying area of the city seven or eight years ago for $800,000 and then the city expanded to his property.  Now the land will appraise for $2,000,000.  Assuming he has no loans against said land the developer has bona fide equity in the land.  So the commercial lending part of the deal is easy.

But a more common scenario is that the developer bought the land just 3 years ago, but he managed to get the property rezoned from agricultural land to residential land.  Even though 3 years is an extremely short period of time for any property to appreciate from $800,000 to $2,000,000 – most commercial lenders will accept such a rapid appreciation if the developer got the land entitled.  Entitled simply means that the land has the right to be developed into homes or commercial buildings such as office space or mixed use properties.

But the commercial lender didn’t come to town on a turnip truck.  The commercial lender’s underwriter is to savvy to fall for the old saw, “I was able to buy the land for $800,000 but I got a really, really good deal.  The property is actually worth $2 million.”  Yeah, when pigs fly.  If the property was really worth $2 million, the seller would have sold it so someone else for $2 million.  Just about all commercial lenders are smart enough to realize this and won’t fall into this trap.

One good way a developer could raise the $2,000,000 is for the existing land owner to subordinate.  Let’s suppose the land owner is asking $2 million for his/her land.  The developer could ask the land owner to carry back a $2,000,000 second mortgage that would be subordinate to the construction loan from the commercial lender.

Another way for the developer to raise the $2 million in equity required by the commercial lender would be to acquire a mezzanine loan of – let’s say $1 million.  (Mezzanine loans have been explained in other articles you can see on this web site.)  Then the developer would only have to raise the remaining $1,000,000 which may a workable alternative for him.  But unfortunately most commercial lenders who handle mezzanine loans will not make “mezz” loans for less than $3,000,000.  Mezzanine financing would probably work on a $30 million project.  The developer could probably not get a “mezz” for a project as small as $10 million.

Another good way to raise equity is through syndication.  The developer simply syndicates a small group of his closest friends into an LLC.  Let’s say that each of these 20 private investor friends put up only $100,000 each.  That would do the trick.  In such cases the developer must be extremely careful not to violate any securities laws and regulations.  He is not allowed to publicly advertise the formation of this investment LLC or use more than 35 accredited investors in the investment group.  Commercial lenders are aware of these rules and regulations and can be good partners in guiding the developer.

It is very important for developers to have close relationships with more than one commercial lender.