Purchasing real estate, whether it's a completed project or a development project, can be risky for all parties involved.
There are a lot of things that can go wrong, and a lot of assumptions that have to be made. One thing that helps to give your lender and other important parties a good feeling about working with you is equity. The more equity you have and use on the project, the more secure the other parties feel.
Skin in the game
You may hear the term "skin in the game" quite frequently if you spend much time working with commercial real estate. The basic concept here is that you have something real at stake in the process. We can use the recent housing crisis to illustrate why this is important. Let's take a look at loans made to two home-buyers in the spring of 2007, when housing was going crazy. Both buyers were purchasing a $200,000 home. One buyer plopped down 20% equity, meaning his loan was only $160,000. The other had no equity, but got a $200,000 loan. Which is safer? The first loan is safer, and it's obvious why.
Imagine if housing prices in your community fell by 40%. The $200,000 homes are now both worth $120,000. (If you think this is unrealistic you should talk to a broker who sells homes in Las Vegas or the San Joaquin Valley in central California. It can happen and has happened.) Now you have individuals who are both living in homes that are worth less than what they owe on them. The first buyer has a loan for $150,000 on a home that is worth $120,000. The second buyer has a loan for $200,000 on a home that is worth $120,000.
Who is more likely to leave? Obviously its person number two, but not for the reasons you might think. The real reason buyer one will be more likely to stay is because of the cash he plopped down at closing. He has skin in the game. It's his money! And even though it's a sunk cost and economists will tell you to forget about it, it's hard to forget about writing out a check for $40,000!
The fundamentals require it
As you can see from the housing example above, the fundamentals of real estate lending require equity in the deal. Even when loan to value ratios are climbing and people anticipate huge rent growth, a good lender will still want to see that the property owner has some equity in the deal to ensure they stay interested.
In commercial real estate, ownership groups often create an LLC for each building they own. This is yet another reason why equity is important. If no one building can endanger the rest of your portfolio, you are less likely to keep working with a struggling project. If you have equity in the deal, your skin in the game might be enough to keep you interested and focused on making the project successful.
Equity requirements force you to think
The final reason I'll submit why equity is important in real estate is that it forces you, as the owner, to really think about what you are doing. If you know in advance that you will need 10% equity for any project you do, it will help you to be selective in picking only the safest projects to work on. You will also focus on how to build up the cash the project requires. This kind of thinking is what the banks want; it helps them screen projects by having you do the pre-screening for them.