Using 100% equity for a project - does it ever make sense?

WizOSRS's picture
Rank: King Kong | 1,555

Just wondering about this, does it ever make sense to not use any debt for a real estate project? Say for example, you're having a difficult time deploying capital because cap rates are super low, but you've found a decent investment. So you want to deploy as much of your equity as possible, you're not worried about being able to invest in another project because other projects are not offering good returns.

Lets assume you have a $500M equity portfolio, and this project is $20M in value.

Does diversification concerns stop you from going all equity?

Do the tax benefits of debt make it worthwhile in this situation?

I just threw out some numbers as an example, I'm interested in the theory behind this

Comments (31)

Dec 13, 2018

If you go full equity, sure your returns might be lower than debt on a % basis, but your gross gain in cash will be higher with all equity? Assuming there's no other projects to invest in, would you go full equity?

Dec 13, 2018

Not RE but maybe there's a similar parallel if you're value-add... We are doing an LBO atm using more equity than we should because we want to keep the pressure/narrow runway associated with a debt load off the operating team until we prove our thesis out. Once the asset is up & running the way we want it to we'll throw some debt on it and issue a dividend.

Dec 13, 2018

That makes sense, basically, the company/project has unstable cash flows and therefore is unable to support debt?

Are you not worried about the opportunity cost of the extra equity you're deploying? In the sense that it could be invested into a project with higher yields because there's more leverage?

Dec 13, 2018

In this case, cash flow is solid, company is growing fast, etc... but we want to make sure there's loads of room to make mistakes. Not concerned about capital being tied up because we're aiming for more than 10x in 2 years or less. We'll start loading the company with debt if our initial thesis plays out well and if it doesn't, then we have lots of room to try various strategies.

Dec 13, 2018

I believe all of Skanska's developments are 100% equity. Chick Fil A's might be too - I'd have to check.

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Dec 13, 2018

Chick Fil A has a development arm, besides the team that does its build-outs?

Dec 13, 2018
C.R.E. Shervin:

Chick Fil A has a development arm, besides the team that does its build-outs?

Yes. That's how new stores are built.

They have a separate rehab team as well for existing store upgrades

Dec 13, 2018

Yes. There are entire funds who purchase core quality assets with 100% equity. See: https://www.ncreif.org/data-products/funds/ Note that Odyssey funds do utilize debt but they do it at the portfolio level rather than the asset level.

Another time this might make sense is if you're an open-ended value fund and need to get equity out the door, ie you have a queue of investors lined up and you need to deploy capital. You wouldn't do this in every circumstance, but there are situations where it might make sense.

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Dec 13, 2018

I mean, the simplest answer (though it isn't really answering the question you're getting at, I don't think) is if you need to move quickly to lock up an asset. If you think you're buying really well, or if there is a pressing timing need to get started on construction (maybe the safe harbor for a tax abatement is fast approaching, etc), then going all-cash and not dealing with the time it takes to go through a credit approval process from a lender makes sense.

Dec 13, 2018

I may be thinking about this wrong, but here goes. Feel free to monkey shit me...

Recently competed w local all equity developer on a large WC land site. They solve to a a RoC, like most do. Thing is... they don't have the $5/10 per BSF in their budget for construction loan interest so they have more room to push. They're strictly yield buyers and will hold forever. not the best guy to go against for a REPE shop.

So my answer is yes, there is benefit to going all cash if circumstances are right.

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Dec 13, 2018

This is a bit of an oversimplified answer, but if your cost of debt is higher than your unlevered yield, it makes sense to use 100% equity.

I come from down in the Valley, where Mr. when you're young, they bring you up to do like your daddy done.

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Dec 13, 2018

Yup. There are not many types of real estate deals where this would make sense. If the cost of debt is higher than your unlevered yield why are you taking the operational risk? Maybe a single tenant NNN deal?

Dec 13, 2018

I'm not sure how you're getting to this conclusion. Unlevered yield is basically the cap rate of the asset assuming 100% equity. If Kd > cap rate that is OK and almost always happens in class A+ assets insofar as the DSCR is sufficient to service the debt understanding LTV < 100%. This only makes sense if debt = 100% LTV in which case your NOI would not be sufficient for debt service and your asset would fail/go into distress.

IMO only makes sense to use 100% equity agreed if there are unstable cash flows of the asset and you need a runway to get to stabilziation. Kind of like VC or any startup company, use all equity going in first and then do a levered recap to take equity off the BS once the asset is stablilzed and can service the debt.

Dec 13, 2018
zacksc11:

IMO only makes sense to use 100% equity agreed if there are unstable cash flows of the asset and you need a runway to get to stabilziation. Kind of like VC or any startup company, use all equity going in first and then do a levered recap to take equity off the BS once the asset is stablilzed and can service the debt.

Huh? As I mentioned above, there are $200+ billion of core funds who buy all-equity and do not utilize this strategy on unstabilized assets. Maybe a small % of their portfolio is carved out for alpha plays where you might take on development risk in a build-to-core strategy (for example), but for the most part you're buying newly-built, stabilized, Class A+ assets in top-20 MSAs.

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Dec 13, 2018

If cost of debt is higher than unlevered yield, it's negative leverage.

I come from down in the Valley, where Mr. when you're young, they bring you up to do like your daddy done.

Dec 13, 2018

Not my shtick, but have heard of MF deals going down with negative leverage. Feels like a sort of cannery in the coal mine to me, no?

Dec 13, 2018

Usually when this happens though (at least from my anecdotal observation) it's a foreign entity that has been living in a negative interest rate reality/environment recently. So if they need to put leverage on it to just get the deal done (don't have a big enough equity check) they'll be fine with diluting the returns just to get it done. If it's a 5 cap deal but the lev. CoC is 3.5% when all is said and done, it's still better than negative return in some alternative investments.

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Dec 19, 2018

a.k.a Akelius

Most Helpful
Dec 13, 2018

I think it makes sense in the following cases (most of which have been explicitly/implicitly explained, but in summation:

-You use the ability to close all-cash as a differentiation/way to expedite closing. Most of these groups will then tack on debt post close at the portfolio level (have a relationship with a lender or a revolving credit line/debt pool).

-You are at a large family office that has enough money to close all-cash and would rather own outright than deal with the risk/head trauma of the debt.

-You like the deal but the returns on the project vs. the debt are upside down (i.e., the debt would be dilutive to the deal). Seeing this a lot in industrial and multifamily right now since the cap rate compression has approached ludicrous speed.

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Dec 13, 2018

Wasn't sure whether to give SB for the helpful recap or the Spaceballs reference...

Dec 13, 2018

"Don't worry about it, we'll meet again in Spaceballs 2: The Quest For More Money."

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Dec 22, 2018

nailed it. if your going in cap rate is lower than your cost of capital and you have limited rent growth YoY, or you plan for a long term hold for a core deal with a 5 to 7% return.

leverage also works against you in a down cycle. you don't have to deal with bank covenants and all the bullshit from lenders.

Dec 13, 2018

Yes, it does make sense to sometimes not use debt. For instance, many life companies invest on behalf of their general account all equity. When they do use leverage, it'll be low. Otherall return is lower, but cash yields might be higher depending on the debt structure one might otherwise use.

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Dec 13, 2018

Yes. If you are doing a land development deal, you'd want to go all equity so that if/when the economy slows down you don't also have a mortgage payment to deal with. You do the acq and horizontals out of equity and fund the vertical (if any) with a loan.

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Dec 19, 2018

short answer yes. more common in NNN structure assets that typically come with lower leverage. Less likely to see 100% cash/equity for a MF development...

Also, a lot of larger public REIT's employ a revolving line of credit. Think of this like a credit card. Over simplifying it, but this is really a short term debt structure that usually results in one company owning 100% of the asset, often through equity.

Again, the word equity and cash gets a little hazy when you're public traded and have stock ownership out in the public market,..

Dec 19, 2018

What is your point with the revolving line of credit? Many funds and investment firms use them as well, typically to close on the acquisition of a property more quickly and then put debt on the asset later.

I thought you were going to say that may REITs address their capital structure at the enterprise level, typically through bonds, rather than encumbering each property. That way they can achieve levered returns and have more flexibility.

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Dec 20, 2018

I think this is more a function of where you are on the risk spectrum. If you want opportunistic type returns then lever up 70-80% LTV. If you're looking for something on par with a treasury bond, then go buy a trophy building at 0% LTV.

Dec 20, 2018

there's a very rich, very well-known family office active in the sunbelt that does some big development deals all-equity

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Dec 13, 2018
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Dec 20, 2018
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