There’s a building, and you want to buy it. It’s a great investment and you’re projecting awesome returns. You have about 10% of the acquisition price available in cash. You know you can get a loan for 70–75%. That means you’re short 15–20% of the purchase price, and you do NOT want to miss this investment deal.
You need to raise equity.
There are a few different ways to raise equity. Let’s look at them.
A classic way to raise equity is to ask for money from individuals, who become Limited Partners on the deal. The limited partners become part-owners of your investment, and usually do not have additional rights to make decisions that affect it (like when to sell).
Typically you’ll solicit investors that you are already acquainted with. In the US, you cannot publicly advertise a private investment opportunity without following the proper regulations. That’s where crowdfunding portals have come into play, as they create a structure to allow more broad syndication of deals to a higher number of random investors that may want a piece of the action. To understand the LP thought process, check out Chris Peters’ recent piece:
Bringing in an equity partner means you’re giving up at least some control. Joint venture partners come in at the General Partner level, rather than as Limited Partners. As a group, the General Partners are responsible for executing the investment strategy.
Sometimes general partners will divide up responsibilities in executing the business plan based on the competencies of each individual partner. One partner may be more skilled in design and development, so they may work more closely with the architect and the construction manager. Another partner may be more skilled at fundraising, so they’d solicit additional capital. Either way, trust and the ability to work effectively as a group to make decisions is key if you’re bringing on a joint-venture equity partner.
Preferred equity partners are similar to LPs, however, they are senior to GP and LP equity in the capital stack. Return structures can vary, however, they typically receive a “preferred return” that consists or current pay or accrued pay or a combination of the two, while also potentially participating in the equity upside. You may see a preferred equity investor make 6–10% current return plus their negotiated share of the promote (increase in equity value).
Very close in relation to preferred equity, mezzanine debt is usually structured as a loan against the project’s equity. The lender typically gets an interest-only return until their position is refinanced out or the property is sold. Mezz loans usually charge a high interest rate in order to plug gaps in funding between the commercial mortgage and the project’s equity. To learn more about mezzanine debt, see our previous blog post on the topic:
You may encounter someone in real estate claiming they are raising equity for a deal, when what they really mean is they are looking for someone to take over the deal entirely. Typically this will be someone trying to make money by identifying a property and then passing it off to someone else who can actually work on the project. While there’s nothing wrong with making connections, this is not considered an equity raise by legitimate real estate investors, because the wholesaler doesn’t really own the deal.