Real estate development is first and foremost a cash flow business.
Real estate is, by its nature, an expensive non-liquid asset. This means that it costs a lot of money to own it, and it can be difficult to sell. In development activity, there are also the added costs of improvements themselves (typically called “hard costs”) and the fees of various and sundry consultants necessary to get the work done properly (typically called “soft costs”). Because expense is high, sale is difficult, and return on investment is delayed, real estate investment is inherently risky. A large part of the work of developers is the management of risk.
Since there are significant initial investment requirements, a majority of real estate development projects are financed with a large amount of debt leverage. While more leverage increases potential profit, it also magnifies risks and builds in a periodic negative cash flow (regular payments on the debt). Projects will generally be profitable if the upfront commitment of cash is kept to a minimum and the project can quickly start generating a positive cash flow sufficient to cover debt service.
There are almost as many ways to finance a real estate development project as there are development projects. However, most financing arrangements fall into a few broad categories:
- Private investors (pension funds, insurance funds, wealthy individuals, joint ventures, etc.)
- Public investors (REITs, share offerings, public-private partnerships, etc.)
- Private debt (individual loans, bank mortgages, construction loans, etc.)
- Public debt (redevelopment loans, etc.)
- Private grants (non-profit target grants, etc.)
- Public grants (anti-blight subsidies, affordable housing credits, tax incentives, historic preservation grants, etc.)
- Equity financing (use of cash flows from other projects owned by the developer)
Successful real estate developers can become enormously wealthy due to the large sums of money being transacted and the value of the assets they control. However, because of the non-liquidity of their assets, they also are very often cash poor. Inability to remain cash solvent is the primary cause of business failure for real estate developers.