What is “Capital Formation” in real estate?

Capital formation is the process of sourcing money to deploy into a deal.

Tim Milazzo
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Capital formation is the process of getting money ready to deploy into a deal.

In real estate, capital formation takes place around three primary events:

  1. Developing a new property/building
  2. Acquiring a new asset (property, building, land, etc.)
  3. Refinancing, also known as “recapitalization”

The amount of capital to that goes into a deal is determined by what you are doing. That would be the counterpoint to capital formation, where you map out the uses of the capital. Typically you build out the Uses side of that Sources & Uses table first, which represents the budget for the real estate deal. A simple deal’s Uses may look like this:

  • Acquire subject property: $4,000,000
  • Capital improvements: $175,000
  • Closing costs: $60,000
  • Total = $4,235,000

In the above example, you would be looking to set up sources of capital that sum to the same total — $4,235,000. Balancing the Sources with the Uses is necessary to execute on the deal.

Types of capital to form

There are different tranches of the “Capital Stack” (an official industry term for all the sources of money for a deal) that can be collected to add up to total budget. If you are the person in control of the deal, you are the deal’s “sponsor”, and therefore responsible for this capital formation.

We’ll work our way from the bottom to the top here. Note that this guide isn’t comprehensive, as other sources of capital exist, but these are the typical ones to know.

Senior Debt

A senior loan is one of the most common sources of capital for real estate deals. Senior debt typically comes in the form of a commercial mortgage, meaning the property is collateral for the loan. The process for obtaining senior debt includes soliciting that loan from a licensed lender, like a bank, credit union, life insurance company, debt fund, or government agency. Many borrowers engage a commercial mortgage broker or a web platform that will allow them to solicit loan offers from multiple lenders more easily.

Mezz Debt

“Mezz” is short-hand for “mezzanine”, or subordinated debt. If a property has senior debt and mezzanine debt, and that property bankrupts, the senior lender gets paid back first.

For a borrower, taking on mezzanine debt is more expensive (high rate, more fees) than a senior loan. However, it allows them to borrow more money from a second lender, which means using less of other sources of capital (like their own equity).

Much like a senior loan, getting access to mezzanine debt typically means soliciting a lending company, though these lenders are usually private debt funds or sometimes even high net worth individuals who provide this type of financing for a higher yield than their senior counterparts. The pitch to a mezz lender will be more focused on the borrower’s track record than senior loan offerings.

We wrote more on the topic of Mezz debt previously here:

Preferred Equity

Every source from here on retains some actual ownership interest in the property, rather than a lien against it. Of the equity positions, the word “Preferred” tells you this source would be more senior, meaning they will get paid back first before other equity sources.

Preferred equity does not technically require a Preferred Return, though it typically does include one. You can read more about how different levels of equity receive returns in sequence here:

The process for obtaining preferred equity is more relationship-based than the process of obtaining a loan. Having a direct relationship or an introduction from someone who has done business with the pref equity investor before is key.

Common Equity — LPs

“LP” stands for “Limited Partner”. These investors provide passive capital for a deal with higher return expectations than any of the capital tranches we’ve covered so far, since they are sharing in the full risk of the deal. After all, each of the other capital sources we mentioned already, if present, will be paid back first.

The process for receiving LP money is very relationship-based. Historically, LPs rarely deploy a lot of capital, if any, with sponsors they have just met (though crowdfunding is doing its part in changing that — slowly but surely). Real estate sponsors usually keep a list or database of all the LPs that they have worked with or solicited for investment in the past.

Common Equity — GPs

“GP” stands for “General Partner”. The deal sponsor is typically one of the general partners, and there can be other general partners that either work as part of the same company, or as separate individuals working together just for the sake of the deal. They share the same level of risk as the Limited Partners.

Other general partners can also be brought in via a Joint Venture agreement, where a different entity with separate equity capital invests alongside the sponsor’s entity as Co-GPs.

Teaming up with other GPs takes the highest amount of trust and cooperation out of any of the capital sources. GPs have the highest potential returns in most deal scenarios, but that comes with the responsibility to actually execute on the strategy, raise the rest of the money, make the right decisions, and operate the investment asset until divestiture.

Alternative capital sources

  • PACE — stands for “Property Assessed Clean Energy”. This capital source is growing in popularity. We’ll do another blog explaining the nuances here.
  • Historic tax credits — different levels of government may provide tax incentives to keep historic buildings looking the way they do. Weird? Maybe. But these incentives are prominent. Another specialty to cover later.
  • LIHTC —stands for “Low-Income Housing Tax Credit”. Like historic credits, governments at multiple levels from municipalities/cities up through national administrations may have different tax credit programs available.
  • TIFs — stands for “Tax Increment Financing”. A local government gives a real estate developer a break on property tax increases in order to help revitalize a community that otherwise wouldn’t benefit from the development.
  • EB-5 — a US federal government program that provides incentives for foreign investors to invest in US job creation, including construction jobs. If the foreign investor contributes enough to job creating investments, they can earn a visa. This would be part of the Equity in the capital stack.

What else? Have you used another alternative source of capital recently for a commercial real estate deal? Let us know.

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