In: Finance
Finance & Real Estate Open Ended Question:
Why do lenders approve of a waterfall in which the equity
investor receives most of the returns?
Answer-
The lenders approve of a waterfall in which the equity investor receives most of the returns in real estate sector because the real estate sector is capital intensive.
Most of the real estate sector projects require lot of capital and the source of funding can be raising debt by loans from financial institutions or banks. The raising of capital can be done by issuing equity as well through IPO or secondary offering of shares that are traded on stock exchanges.
The equity investors are entitled to receive most of the returns as the debt raised will increase the leverage and the cost of equity raises due to the risk involved in the investment. The increase of debt will not significantly impact the cost of debt but the debt raised increases the debt/ equity ratio and the company will be leveraged increasing the default risk thus increasing the cost of equity. As the equity holders will require more returns that debt holders due to higher risk and therefore the cost of equity increases to compensate the risk involved in te project.
These reason prompts the lenders to approve the waterfall in which the equity investor to receive most of the returns justifying the increase in risk involved due to leverage involved in real estate projects.