The equity cheque is the same size either way; what changes is when it goes in, and so the interest and the return.
Pro rata funding gives the higher equity IRR and equity first the higher profit. On an illustrative 24,000,000 scheme funded 35 per cent with equity and 8 per cent rolled-up debt, equity first earns 3,886,625 of profit at a 24.9 per cent IRR; pro rata earns 3,479,443 at 33.7 per cent. The same 8,400,000 of equity is simply out for less time under pro rata, which pays 407,182 more interest to buy that IRR.
Worked in full in Real Estate Financial Modeling by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The funding order is one of the first switches in a development model, and one of the least discussed in a committee paper. The equity cheque is the same size either way. What changes is when it goes in, how long the loan runs at each balance, and so both the interest bill and the time-weighting of the return. Model it monthly; an annual model blurs most of the difference.
| Input | Value |
|---|---|
| Land and acquisition costs, month 0 | 6,000,000 |
| Build costs, months 1 to 18, even | 18,000,000 |
| Total cost before finance | 24,000,000 |
| Equity, 35% of cost before finance | 8,400,000 |
| Loan interest, rolled up monthly | 8% a year |
| Net sale proceeds, month 21 | 29,000,000 |
The loan funds every cost the equity does not, plus all its own interest, and is repaid from the sale. To keep the comparison clean, fees are left out and the lender is assumed willing to fund land pro rata, which many will not before planning.
Equity first: equity drawt = MIN(costt, equity commitment − equity drawn to date); the loan draws the rest.
Pro rata: equity drawt = costt × 35%; the loan draws costt × 65%.
Loant = loant−1 × (1 + 8% ÷ 12) + loan drawt
In Excel, equity first: =MIN(Cost,EquityCommit-SUM($D$10:D10)) in each month's equity cell, the previous cells summed to date. Equity IRR: =(1+IRR(EquityCF))^12-1, compounding the monthly rate rather than multiplying it by twelve.
Under equity first the 8,400,000 pays for the land, 6,000,000, and the first 2,400,000 of build, so the loan starts drawing in month 3. Under pro rata the equity goes in alongside every cost: 2,100,000 at month 0 and 350,000 a month after that.
| Measure | Equity first | Pro rata |
|---|---|---|
| Interest rolled up | 1,113,375 | 1,520,557 |
| Peak loan, repaid at sale | 16,713,375 | 17,120,557 |
| Peak loan to total cost | 66.6% | 67.1% |
| Developer's profit | 3,886,625 | 3,479,443 |
| Profit on cost | 15.5% | 13.6% |
| Equity multiple | 1.46x | 1.41x |
| Equity outstanding, average years | 1.71 | 1.16 |
| Equity IRR | 24.9% | 33.7% |
Pro rata costs 407,182 more interest because the loan is drawn from day one, including on the land, and that interest compounds for the whole programme. Profit on cost falls from 15.5 to 13.6 per cent. But the equity is outstanding for 1.16 years on average instead of 1.71, so the IRR rises by 8.8 points. Which one is better depends on which measure the investor is paid on and what else the capital could be doing in the first months.
| Case | EF profit | EF IRR | PR profit | PR IRR |
|---|---|---|---|---|
| Interest 6% | 4,172,880 | 26.6% | 3,874,521 | 37.3% |
| Interest 8% (base) | 3,886,625 | 24.9% | 3,479,443 | 33.7% |
| Interest 10% | 3,594,922 | 23.2% | 3,073,951 | 30.0% |
| Sale six months late, month 27 | 3,206,848 | 15.8% | 2,783,105 | 18.6% |
| Net sale 10% lower, 26,100,000 | 986,625 | 6.7% | 579,443 | 5.9% |
The IRR advantage of pro rata shrinks in every downside, and in the value downside it reverses. The extra interest is a fixed cost that comes out of the developer's profit whatever the sale achieves, so when the margin thins, the time advantage stops paying for it. On this scheme the two orders give the same IRR, 8.3 per cent, at net proceeds of 26,339,318, a 9.2 per cent fall from the base. Below that, equity first returns more on both measures. Even a lender charging pro rata 2 points more, 10 per cent against 8, leaves pro rata ahead in the base case, 30.0 against 24.9 per cent, which is why sponsors push for it.
The common mistake is to switch the funding order and compare IRRs while holding the interest constant: copying the finance cost from the equity-first case into a pro rata model, or sizing equity as a share of cost including finance and then not iterating. The drawing order changes the interest, the interest changes the loan, and in a model that sizes equity on total cost the loan then changes the equity. Either fix the equity cheque and let the loan absorb the interest, as here, or solve the circularity explicitly; never compare two orders on one interest figure.
A second check. Under equity first, the month the loan starts drawing should be the month cumulative cost first exceeds the equity commitment: month 3 here, when cost reaches 9,000,000 against 8,400,000. If the loan draws earlier, the MIN formula is reading the wrong running total.
Equity first maximises profit, 3,886,625 against 3,479,443 here; pro rata maximises IRR, 33.7 against 24.9 per cent, and loses that edge once the sale price falls about 9 per cent. Show both measures and the crossing point, because the order is a negotiated term, not a modelling convention. The free companion workbooks for the book include a timed development residual case to practise this kind of build on, and LTC vs LTGDV development finance shows how the lender's limits size the same facility.
Because the developer's money is spent before the lender's, so the loan is drawn later and at a lower balance, and the equity is at risk first. In the illustrative scheme the peak loan is 16,713,375 under equity first against 17,120,557 pro rata, with 407,182 less interest rolled up.
No. It pays more interest, a fixed cost against the sale price, so its advantage shrinks in every downside. In the example the two orders tie at an 8.3 per cent IRR when net proceeds fall 9.2 per cent, and with a 10 per cent fall equity first returns 6.7 per cent against 5.9.
Each month's equity draw is MIN(cost, equity commitment less equity drawn to date), and the loan draws the remainder plus its interest. With 8,400,000 of equity against 6,000,000 of land and 1,000,000 a month of build, the loan starts drawing in month 3.
This article is one calculation from Real Estate Financial Modeling. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.