The nature of real estate is such that it requires large amounts of outflows in the development stage. Real estate companies have to resort to alternatives so as to raise finance to carry on their developments. Usually large well established developers can resort to many sources of raising funds on the market at lower cost. This is as a result of experience and knowledge on the market. Usually major real estate projects are carried on by larger developers. This paper discusses merits and demerits associated with debt and equity funding as sources of funding.
Debt financing refers to the money borrowed from a lender to fund real estate projects at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the maturity date, but periodic coupon payments may be part of the loan arrangement. When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and or institutional investors, in return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid, this is generally referred to as debt funding. Debt may take the form of a loan or the sale of bonds. When an economy is performing well, using debt funding is the most prominent way of financing real estate projects due to complexity and demands of the project.
Advantages of debt funding
There is generally a cost reduction in debt funding to the developer. Comparing equity and debt funding, debt requires lower financing cost. Thus, real estate developers often mix debt into their capital structure to bring down the average financing cost. Using debt, companies are contractually liable to make periodic interest payments and return debt principal at maturity. As a result, debt holders bear less risk, compared to equity holders, who often have no recourse for their investments if companies fail.
Debt financing allows one to be able to afford construction of large new buildings, equipment and other assets given the developer have intentions of retaining the building for himself to generate returns when renting it out. This can be a great way to pursue an aggressive growth strategy, especially if one has access to low interest rates. Closely related is the advantage of paying off a debt in installments over a period of time. Relative to equity financing, one also benefit by not relinquishing any ownership or control of the business.
Debt may add pressure to a real estate development company’s ongoing operations as a result of having to meet interest-payment obligations, it helps retain more profits within the company compared to using equity, which requires the sharing of company profits with equity holders. The retained profit can be put to other profitable use. Using debt, companies need to pay only the amount of interest out of their profits when one has obtained an interest only debt. Using equity, on the other hand, the more profits a developer makes, the more it has to share with equity investors
Using debt financing to fund real estate projects is regarded as advantageous to existing shareholders because of the effect of financial leverage. That is, when debt used, equity owners get to keep any extra profits generated by the debt capital, after any interest (coupon) payments. Given the same amount of equity investments, equity investors have a higher return on equity because of the additional profits provided by the debt capital. As long as using debt does not threaten the financial soundness of a company in times of difficulties, equity owners welcome certain debt uses to help enhance their investment returns.
Disadvantages of debt funding
The most definite drawback of debt financing is that one has to repay the loan, and also adding the interest. Failure to do so exposes a major real estate project to repossession by the bank or respective fund provider. Debt financing is also borrowing against future earnings.
When developing major real estate projects which are income generating properties, the developer may find the process of obtaining financing more complicated because in some cases two lenders, construction and permanent, are involved
Generally lenders of finance are mostly interested on what can be developed on the site. This means that proposals submitted to potential debt providers will provide a fairly detailed description of the size, design, and cost of the project. The submission will also provide a detailed market and competitive analysis, identify the team that will develop the project, and document all public approvals obtained or needed relative to zoning and permitting.
Equity funding refers to money raised by the company that becomes part of the company’s assets. Equity is cash paid into the business, either the owner’s own cash or cash contributed by one or more investors. Equity investments are certified by issuing shares in the company. Shares are issued in direct proportional to the amount of the investment so that the person who has invested the majority of the money in effect controls the company. The providers of finance are not entitled to interest but get ownership in the form of shares. Shareholders are entitled to dividend income, the right to vote on shareholder resolutions and in the event of liquidation, all shareholders get the residual interest after all creditors have been paid off in full. Investors put cash into a company in the hope of sharing in its profits and in the hope that the value of the stock will grow or appreciate in value. They can earn dividends that is the share of the profit but they can realize the value of the stock again only by selling it.
Advantages of Equity funding
Equity financing does not have to be repaid, this means that when shareholders have contributed to the construction of a major real estate project, the developer will not have to be worried about finding ways to repay the initial deposits by the shareholders. This is major advantage of equity finance to a real estate developer. The funding is committed to the business only and its intended projects.
It is important to note that equity finance results in sharing of the risks and liabilities of company ownership with all the investors. Since a real estate developer does not have to make debt payments, one can use the cash flow generated to further grow the major real estate development or to diversify into other areas. Maintaining a low debt-to-equity ratio also puts a company in a better position to get a loan in the future when needed.
Equity finance enables a developer only to concentrate at what he knows best that is to continue development of large real estate projects. A developer will not have to keep up with costs of servicing bank loans or debt finance, allowing him to use the capital raised from equity for construction activities that will guarantee him of a future earnings in the future.
Investors in equity finance have a common aim and idea with the development company since they have a vested interest in the business’ success that is they will try their level best to ensure company achieves growth, profitability and increase in value. The right business partners and venture capitalists can bring valuable skills, contacts and experience to the developer’s business.
Disadvantages of Equity funding
By taking on equity investment, this implies that the development company is giving up partial ownership and, in turn, some level of decision-making authority over the business. Large equity investors often insist on placing representatives on company boards or in executive positions. This has the overall effect on neutralizing and diluting the company board.
Raising of equity finance is demanding, costly and time consuming. Given that a company wants to first show up on the Botswana Stock Exchange (BSE), it firsts offers an Initial Public Offering on the BSE, this means that time will be consumed by trying to convince potential investors to invest in the company and also a lot of sunk costs will be incurred in the process.
Only large and well established companies will easily access equity finance as compared to small inexperienced young property development companies hence small developers are not given an opportunity to demonstrate what they are able to do since potential investors normally seek comprehensive background information on the reputation of the company and its board of directors.
Investors’ should prioritize accessing the company’s debt to equity ratio. Lenders like to see a lower debt/equity ratio because more of the company’s fortunes are based on investments, which in turn means that investors have a high level of confidence in the company. If the debt/equity ratio is higher, it implies that the business has borrowed a lot of money on a small base of investments. It is then said that the business is highly leveraged. This in turn means that lenders are more exposed to potential problems than investors. Investors like to use a small investment and leverage it into a lot of activity by borrowing whilst lenders like to lend a small amount secured by a large investment.