According to the NYU School of Business, the average cost of capital in real estate development is 5.43%. Does this surprise you? With interest rates lingering in the 8s for some time now, an average cost of capital below the prime rate can seem impossible.
Lowering your company’s cost of capital is possible. The first steps are to understand how to calculate the cost of capital in real estate development, decipher the impact of financing sources on overall project costs, and the importance of accurately estimating capital expenditures, all of which we’ll cover in this article.
What is the Cost of Capital in Real Estate Development?
The cost of capital in real estate is the return that investors and lenders require to make an investment. For example, a bank might only be willing to issue a loan if the interest rate is 7%, while a private investor might require a 10% return. The cost of capital measures both debt and equity financing sources.
Understanding the cost of capital is a fundamental component of the real estate development industry. It indicates how much money your company needs to raise, highlights potential profitability, and evaluates whether a project is worth undertaking.
Let’s say that your cost of capital is 8%, but your project is only expected to return 5%. In this situation, your firm would need to pivot to reduce capital costs or eliminate the project altogether.
Common Real Estate Development Capital Sources
There are two primary sources of real estate development funding: debt and equity. Let’s go through some of the common financing sources for each category.
Debt Financing
Deft financing involves capital that is expected to be repaid. Debt financing does not dilute ownership percentages, gives your company access to capital, and opens the door to a tax deduction through interest expense. Common debt financing sources include hard money loans, term loans, lines of credit, and seller financing.
Equity Financing
Equity financing exchanges an ownership interest in the company for upfront capital. For example, an investor might contribute $200,000 in return for a 10% ownership stake in future earnings. Common equity financing sources include angel investors, venture capital, bootstrapping, and some convertible debt.
Calculating Weighted Average Cost of Capital (WACC)
Weighted average cost of capital is the overall capital derived from all capital sources, including debt and equity. This calculation helps you identify your average capital cost rate according to preferred or existing capital structures. Before we can get into the weighted average cost of capital calculation, we must first outline the calculations for debt and equity financing.
- Cost of Debt = (Interest Expense / Total Debt) x (1 – Marginal Tax Rate)
- Cost of Equity = Risk Free Rate of Return + (Beta x (Market Rate of Return – Risk-Free Rate of Return))
Cost of debt factors in tax savings because interest expense is a qualifying business expense. In the cost of equity formula, beta refers to the company’s volatility relative to the market. A beta greater than one indicates a more volatile share price. Now, here’s the formula for weighted average cost of capital:
- Weighted Average Cost of Capital = (Cost of Debt x Percentage) + (Cost of Equity x Percentage)
WACC Example
Going through an example will help solidify the concepts of the weighted average cost of capital calculation. Let’s say that your real estate development firm is considering a new project. Currently, you expect the project to be financed 60% with debt and 40% with equity. Your company’s marginal tax rate is 21% and your team is securing a $1,500,000 loan at 7%. Let’s also assume your company’s beta is 1, the current market return is 8%, and your investors want a 9% return. Here’s how we would calculate WAAC:
- Cost of Debt = 7% x (1 – 21%) = 5.5%
- Cost of Equity = 9% + (1 x (7% - 9%)) = 7%
- WACC = (5.5% x 60%) + (7% x 40%) = 6.1%
In this example, the weighted average cost of capital is 6.1%. If the project were to generate a profit above 6.1%, it would most likely be approved. Anything under 6.1% would result in a loss.
The Impact of Financing Sources on Overall Project Cost
Financing sources have a significant impact on overall project costs and financial projections. For one, taking on too much debt or equity could erode profitability. For example, if your real estate development company solely uses debt financing with adjustable interest rates, you could see negative returns in periods of rising interest rates.
By strategically deploying both debt and equity financing, you can find an optimal balance that effectively manages risk and return. If your firm requires a 2% profit margin over the weighted average cost of capital, you need to understand the impact each additional financing source has on that equation.
For example, if your weighted average cost of capital is already treading close to your margins, it wouldn’t make sense to take on high-interest debt. Instead, you might want to source equity investors. Uncovering the best strategies and financing sources for each development project is crucial to align expectations with actual results.
The Importance of Accurately Estimating Capital Costs
Estimated capital costs are important throughout the duration of real estate development projects, not just in the upfront due diligence phase. For one, your projections and forward-looking statements need to consider the worst-case scenario. What happens if your project runs out of cash? What is the impact of interest rates rising? What if investor expectations change? Each of these scenarios should be accounted for when developing accurate capital cost estimates.
Cost of capital can also help determine your company’s valuation. A company with a high cost of capital can expect lower profit margins. This can result in the perception of less value. By accurately estimating capital costs, you can gain insight into investor perception, helping you successfully raise more funds in the future and implement agile decision-making to improve your metrics.
Summary
Cost of capital is an important calculation in the real estate development industry. If you’re looking for more ways to expand your education and insights in the real estate industry, check out our courses at Wisdify. We offer a Real Estate Finance course that earns you CPE credits while covering the fundamental concepts you’ll encounter in the field. Reach out to a team member or explore our course catalog for more information.