The Three Kinds of Capital Behind a By-Right Deal

At BETTER, we talk a lot about why by-right development works. We talk much less about how it gets funded, which leaves out most of the story, because the capital stack is where this strategy either works or doesn't.

Every deal we do needs three separate kinds of financing. Two of them are solved. The third one isn't, and almost nobody is set up to provide it.

1. The Purchase

The answer here changes depending on what we're doing with the existing house.

When the house stays. 

Sometimes we buy land with a house on it, split the lots off the back, and keep the house standing, rehabbing it and then renting or selling it. That case is straightforward. A conventional rehab loan handles it. The one thing we watch closely is whether the lender gives us credit for the new lots in the after repair value. If the ARV only reflects the house, the improvement doesn't look large enough to justify the loan, and the deal stops penciling. Not every lender will underwrite it that way, and that alone narrows the field of who we can work with.

When the house comes down. 

The moment we're demolishing, the rehab loan is off the table and we're asking for a land loan instead. Two problems show up immediately.

1. Appraisals -  Land value is hard to predict, and these loans live and die on the appraiser's number. We can underwrite a lot of things. We can't underwrite what an appraiser is going to say, and that uncertainty sits at the front of every deal.

2. Proceeds - Because of how volatile land is perceived to be, most lenders top out somewhere around 60% to 70% of value. That is not enough to purchase the property, demolish the house, and still fund a construction deposit to get vertical.

   
   

The frustrating part is that the process itself isn't risky. Knocking the house down moves the land toward its highest and best use, which means we are increasing value, not putting it at risk. But we're changing the nature of the product, and most lenders in this space are traditional about wanting to see standing collateral. The house is the thing they can point to, so removing it reads as risk even when it's the opposite.

What has worked for us is private capital - aka getting a loan from individuals. People willing to fund at 12% or 13% for three to six months while we get the deal to the construction stage. They tend to be people who can look at the mechanics and see that the risk is at or below what that rate implies. We're always looking for more of them.

2. Vertical construction

We want to be clear that this one is not a gap.

New construction lending is abundant. We have partners we're happy with, and we get pitched daily: 85% of cost, 90%, interest reserve, 72.5% loan to value, 75%. There are endless small variations between one lender's terms and the next. But unless someone shows up with a product that meaningfully beats what we already have, and most don't, there's nothing here we need to go solve.

3. Equity

We need equity partners on every deal, without exception. No construction loan is going to fund 100% of the land and 100% of construction cost, so there is always a gap, and equity is what fills it.

Generally we look to raise around 20% of total project cost, counting purchase and construction. That capital funds the construction deposit, covers the spread between project cost and what the lender will advance, carries interest over the life of the loan, and leaves a reserve for whatever goes wrong, because something usually does.

Our equity investors take high teens to low twenties returns. They don't hold a lien, and we're upfront about that. What they get in exchange is a return profile attached to a simple proposition, which is that we're going to build a house and sell it.

Where the gap actually is

It isn't equity. Limited partners are a competitive space, and while we're always talking to good ones, we wouldn't call that the bottleneck. It isn't construction lending either, for the reasons above.

The gap is land acquisition.

If you're a full-scale developer building a hundred houses at a time, there are known sources who will fund your land and your feasibility work. That infrastructure exists. But we don't need feasibility, and we're not willing to pay for a service we're not using. What we need is short-term capital for the acquisition and demolition phase, priced to the risk in front of it rather than to a category.

That product doesn't exist off the shelf, and we think the reason is structural. We're doing something unusual inside a system built to underwrite the standard case. When a deal doesn't match the template, the capital doesn't come looking for you, and you end up going out to find it yourself.

We're going deeper on all of this on September 11 at our next Coffee and a Case Study, where we'll walk through a live deal, the full stack behind it, and the points where the numbers get tight. If this is the part of the business you find interesting, that's the room to be in.