Real estate entrepreneurs with limited or no personal investment capital are often interested in doing deals using “sweat equity”. We discuss this equity partnership tactic below.
What is sweat equity?
First off, let’s define equity. In the typical real estate capital stack (capital structure), you have both debt and equity. Assuming there is only one loan, that debt takes the form of a senior mortgage. The senior debt is secured by the real estate and its associated cash flows, and it places a legal lien on the property that remains in place until the loan is paid back in full.
Equity is the ownership interest in the property. If there is senior debt, the ownership interest is subordinate to that debt. Equity has the “residual claim” on the property’s cash flows, meaning that the monthly cash flow that will pass to equity (if any) is just the amount in excess of the monthly debt service payment amount. The same goes for the net sales proceeds upon disposition — only the amount in excess of the remaining outstanding loan balance will pass to equity.
“Sweat equity” is something that comes into play if there is more than one equity player, where the deal sponsor’s money partner (a third party investor) invests the majority or all of the cash in the deal, and the sponsor invests minimal cash and/or contributes their labor and expertise to execute on the investment strategy. For instance, the sponsor of a development project could contribute their development management services to the deal, forfeiting their typical receipt of a cash development fee drawn down over the course of construction.
In return for non-cash value the sponsor contributes, the sponsor and the money partner will agree on a dollar amount associated with that value, and this amount gives the sponsor a pro-rata ownership interest in the deal.
An example of how sweat equity can be structured
James Smith is a real estate developer/owner in Los Angeles. He puts a foreclosed mansion under contract with the intent to renovate and flip it. He arranges for a senior construction loan of 60% loan to cost and he gets a third party equity investor lined up to contribute the majority of the equity.
The total project cost will be $5 million, funded as follows:
- $3MM senior debt from the construction lender
- $1.8MM in cash from the third party investor
- $200,000 in cash from James
The $5 million total cost above excludes the $100,000 developer fee that James is contributing to the deal. For the $200,000 in cash invested, James has a 10% equity ownership interest in the property ($200K/$2MM total equity), and the third party investor has a 90% interest.
For the contribution of his $100K developer fee, James is granted an additional interest of $100K/$2.1MM, or ~4.8%. This is James’ sweat equity.
Taking the sweat equity into account, James has a ~14.8% ownership interest in the deal, and the third party investor has an ~85.2% interest. Essentially James is getting a promoted interest in the transaction, or “promote”, that is tied to the sweat equity labor he contributes.
How to model 100% of the sponsor equity as sweat equity
What if there is no developer fee because the deal isn’t a development transaction, and the sponsor James Smith does not want to put in any cash equity at all? Let’s assume we have an acquisition of an existing income-producing property controlled by James Smith. In return for finding the deal and for his future management of the asset, he wants to get a share of all cash flows pari passu (pro-rata, simultaneously) to the cash third party investor.
To model this all we do is take the property-level levered cash flows (cash flows to all equity in aggregate) and apportion it based on the negotiated split as a promote amount to the sponsor. See the “Structure” tab of the analysis below for a simulation of this. Click the blue View full analysis button to see the entire analysis and to modify the promote structure.
See here for full instructions on how to model sweat equity in Valuate.