The “Sources and Uses” is often a common place for confusion amongst new professionals in the commercial real estate industry. What exactly is the “Sources and Uses,” you ask? It’s relatively simple once a few points are clarified. The “sources” represent the sources of capital in a deal (i.e. debt and equity). The “uses” are the uses of capital, or more plainly stated, the costs of the deal. A boss once told me that “Sources and Uses” is a misnomer because the uses really drive the sources and therefore it should be called “Uses and Sources.” This simple explanation really drives home the point of Sources & Uses: you need to understand your “uses” before you can determine your “sources.” Let’s dig in a bit.
Consider a simple transaction: the acquisition of a 20-unit multifamily property that needs some modest renovation. The buyer has an accepted offer to acquire the property for $10 million. He/she estimates that an additional $1 million will be required for renovations plus an additional $50,000 for closing costs. Here, we started with the “uses” because remember that you need your uses before you can start thinking about your sources.
Now we have $11.05 million of total uses so we can begin thinking about how we are going to “capitalize” this transaction (i.e. what our sources will be). Now, let’s assume that the buyer has a term sheet from a local bank for a 70% LTC (loan-to-cost) senior loan. He/she will need to raise the remaining 30% as equity for the transaction. Let’s work up our sources to combine with our uses.
Rules of Sources & Uses:
- Start with your uses then think about your sources.
- Sources must equal uses.
- The total (either total sources or total uses) is the total capitalization of your deal.
Another way to try and digest the Sources & Uses concept is to compare it to a balance sheet for those accounting-minded readers. Remember the dreaded balance sheet formula from financial accounting: Assets = Liabilities + Shareholder Equity. If we translate this into real estate, we get something like: Total Capitalization = Debt + Equity. Essentially, you are using debt (“liabilities”) and shareholder equity (collectively, your “sources”) to buy assets (your “uses”). Take a look at the above example restated into the form of a “balance sheet” below:
There are also several different ways to think about structuring your equity in a transaction. Will it be self-funded? Investors? A JV partner? We will dig into this concept in more detail in a future post about how equity can be raised/structured in a deal. For this basic example, our goal was to keep it simple by showing one single source of equity in the deal. Stay tuned for more.