Equity

Equity is the money in a project that is not borrowed. If a lender will fund 65% of total development cost, the other 35% is equity, contributed by the developer, its partners, or outside investors. Equity holders own the building; the lender simply has a claim on it until repaid.

Equity is riskier than debt because it is paid last. If a building earns less than expected, the lender still receives its full debt service and the shortfall comes out of the equity's return. If the building fails, equity is wiped out before the lender loses anything. In exchange for going last, equity investors require a higher return than lenders, and in a new development, one that includes compensation for construction and lease-up risk.

Our default assumptions use a 35% equity share and an 8% cash-on-cash target. In the illustrative 100-unit building that is $8,400,000 of equity requiring $672,000 a year of cash flow after the mortgage is paid. That $672,000 is part of the net operating income the building must produce, and so it is part of the rent.

Equity is often layered. A developer might contribute a small share and raise the rest from a fund or wealthy individuals, with the outside investors receiving a preferred return before the developer shares in profits. We explain why equity investors set the returns they do in Lesson 6: Why Investors Require Returns.