As investors transition from residential to commercial real estate, one of the largest obstacles they face is raising capital for these larger commercial deals. While raising capital can appear challenging and complicated to new investors, plenty of straightforward options exist to raise funds for a commercial real estate project.

In this article, I’ll provide an overview of commercial real estate capital and some strategies on how to raise it. Specifically, I’ll dive into each of the following topics:

● Investment Capital Defined

● Debt vs. Equity

● Pros & Cons of Outside Capital

● Structuring the Deal

● The Pitch to Potential Investors

● Sources of Capital and Tips on Finding Investors

● Final Thoughts

Investment Capital Defined

Put simply, investment capital entails the money an investor uses to actually fund a commercial real estate project. While every deal - and its associated financing needs - is different, common uses of investment capital include:

● Down payments for a project

● Loan-related closing costs

● Building renovations

● Commercial tenant improvements

● Stabilized property operating costs

● Loan curtailments

Bottom line, no matter what you need capital for in a particular deal, you will need capital to finance commercial real estate projects.

Debt vs. Equity

In discussing investment capital for a commercial real estate deal, new investors need to first understand the two broad categories of capital: debt and equity.

● Debt: This refers to borrowing money to finance a deal. When real estate investors refer to debt, they’re typically discussing a mortgage, or loan secured by a piece of real estate. With debt financing, investors need to make regular loan payments, regardless how a property performs (though the interest portion of these payments is generally tax deductible).

● Equity: This refers to actual ownership in a project. With equity financing, investors gain an ownership stake in a project in return for the funds they contribute. While equity financing provides a hedge against poor performing projects - as regular payments are not required - it also dilutes the primary investor’s ownership stake in a project.

Most commercial real estate deals involve a blend of both debt and equity, with the actual blend often referred to as a deal’s capital structure. In this article, I’ll discuss raising outside equity capital for an investment, specifically.

Pros & Cons of Outside Capital

As investors consider a capital blend for a commercial real estate project, they need to understand the considerations inherent to bringing in outside equity investors in order to determine what makes the most sense for that particular deal.

While investors can gain significant advantages from raising outside funds, they also need to understand the associated drawbacks to make informed decisions.

Outside capital pros:

● Increased scalability, as you’re no longer limited by your own capital.

● Outside investors can contribute their experience to a deal in addition to their capital.

● Additional investors provide redundancy, as they will inevitably “sanity check” your decisions, helping you to A) avoid mistakes, and B) make sound investment decisions.

Outside capital cons:

● Outside investors dilute your ownership stake in a deal.

● When people contribute money, they gain a vested interest in the project, meaning you no longer call all the shots.

● Outside investors increase the tax, accounting, legal, and operational complexity of any commercial real estate deal.

Local commercial real estate professionals can help you consider outside capital options for your market and unique situation - need help finding reliable ones in your area? Drop us a note!

Structuring the Deal

Once you’ve considered the pros and cons of bringing in outside capital, the next step in bringing in those funds is figuring out how to structure the deal. In addition to determining the best legal entity for a particular deal (e.g. LLC, LP, corporation, etc), investors should formalize operating agreements that outline, at a minimum, the following:

● Equity structure of the deal

● Management and operations of the stabilized property

NOTE: Typically, outside investors join a commercial deal as limited partners or non-managing members of an LLC, leaving the management and operations to a primary investor, though this should still be confirmed in a formal operating agreement.

● Decision-making criteria for major events (e.g. property disposal, major renovations, owner transfers, etc)

● Maintenance of books and records

● Allocation of profits and distributions

While an operating agreement protects individual investors, developing one also forces you to consider the full lifecycle and associated contingencies of a commercial real estate deal. Bottom line, an operating agreement is a fundamental part of both A) soliciting outside capital, and B) setting a deal up for success.

Feel free to drop us a note if you need help structuring a commercial deal. This process can seem challenging, and we’re happy to help!

The Pitch to Potential Investors

Okay, now that I’ve decided to seek outside capital, how do I actually pitch potential investors?

Great question! And, while I’ll discuss the formal elements of a pitch below, the most important part of any pitch is the way you present yourself to investors, that is, you need to appear professional and competent. You’re asking people to part with a lot of money, and they want to make sure you’re up to the task of properly managing that money.

Having said that, pitching investors requires a formal, legal document known as an offering memorandum. In a nutshell, this document provides potential investors all the information necessary to make an informed decision about whether or not they should invest in a commercial real estate deal.

While a particular deal’s characteristics will drive the contents, here are the major elements of any offering memorandum:

● Your objectives with the property

● The risks associated with the project

● Investment terms and conditions

● The commercial real estate team members, to include their bona fides / experience

● Pro forma financials of the deal

Need help crafting an offering memorandum? Drop us a note, and we’ll be happy to help.

Sources of Capital and Tips on Finding Investors

Armed with a solid offering memorandum, investors next need to seek out capital. While experienced commercial real estate investors with a track record of success may have potential investors reach out to them, most new ones need to actively solicit capital.

Here are the most common sources of commercial real estate outside capital:

● Private money (i.e. “traditional” investors)

● Self-directed IRAs

● Crowdfunding

● Hard money (a.k.a. “bridge” loans)

And, for new investors looking at tapping into some of these sources of capital, here are some places and ways to find investors:

● Current investors (if they’ve invested with you before, they’ll likely invest with you again.)

● Friends and family

● IRA custodians (who manage the self-directed IRAs mentioned above)

● Established commercial real estate professionals

● Charity events (people who donate money typically also have money to invest, and becoming involved with local charities can be a great way to network.)

● Local real estate investor groups

Final Thoughts

Now that you understand the major considerations of investment capital, you can A) decide what makes the most sense for a particular commercial real estate deal, and B) structure that deal accordingly.

At the end of the day, most commercial real estate investors don’t have enough cash on hand to self-finance deals, and outside equity helps plug this funding gap. As such, new investors need to develop - and protect - their professional reputations. Capital inevitably flows to solid deals, and solid deals are driven by true professionals.

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We recognize that, even after outlining the above information, tackling the challenges of raising capital in the commercial real estate world can seem daunting.

That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!

How To Raise Capital | Commercial Investment 101