The Power of Leverage

If you're a landowner thinking about partnering with a developer—or selling your land to one—there’s one word you need to understand: leverage.

Leverage is the lifeblood of real estate development. It’s how developers turn a few million dollars of their own money into $50 million projects. When it works, it creates massive returns. When it doesn’t, it can wipe them out completely. Here’s what that means, and why it matters to you.

What Is Leverage in Real Estate?

In simple terms, leverage means using borrowed money to increase potential returns. Developers rarely fund projects with all their own cash. Instead, they stack different sources of capital to finance a deal. This is called the capital stack.

Understanding the Capital Stack

The capital stack is the structure that shows where the money to build a project comes from—and who gets paid first if things go south.

1. Construction Debt (Senior Loan)
This is the biggest chunk of the money and comes from a bank or lender. It’s typically 60%–70% of the total project cost. It’s also the least risky (for the lender), because it gets paid back first. That means if the project fails, they get whatever cash is left before anyone else.

2. Limited Partner Equity (LP Equity)
This is money raised from investors. These are individuals or institutions who put up capital but don’t run the project. They expect a strong return for taking on more risk than the bank. If the project succeeds, they make good money. If it doesn’t, they may get little or nothing.

3. General Partner Equity (GP Equity)
This is the developer’s money—usually the smallest portion of the stack, but with the biggest upside. The developer also gets something called a "promote," which is a cut of the profits above a certain return. This is where the real money is made. But if the deal underperforms, their equity (and reputation) is the first to get hit.

How Leverage Can Supercharge Returns

Let’s say a developer wants to build a $40 million apartment complex. Here’s how the capital stack might look:

• $28 million in construction debt (70%)

• $10 million in LP equity (25%)

• $2 million in GP equity (5%)

The project is built and stabilized, and three years later it sells for $50 million. After paying off the $28 million loan, there’s $22 million left over.

Let’s assume the net profit is distributed as follows:

• LPs receive a preferred return of 8% annually (compounded)

• After the preferred return and return of capital, remaining profits are split 70% to LPs / 30% to GP

Breakdown After 3 Years:

Preferred return to LPs (8% annual, compounded for 3 years):
~$2.6 million
Return of capital to LPs:
$10 million
Remaining profit to split:
$22M - $10M - $2.6M = $9.4 million

Split of remaining profit:

• 70% to LPs: ~$6.58 million

• 30% to GP: ~$2.82 million

Investor Returns

Limited Partners (LPs)

• Total received:
  $10M (capital) + $2.6M (pref) + $6.58M (profit share) = $19.18 million

• Equity multiple: 1.92x

• IRR: ~24.6%

General Partner (GP)

• Total received:
  $2M (capital) + $2.82M (promote) = $4.82 million

• Equity multiple: 2.41x

• IRR: ~34.4%

These numbers show the magic of leverage. With $2 million invested, the GP walks away with nearly $5 million in three years—more than doubling their money with a high IRR. But remember: if rents drop or costs climb, those same returns can vanish fast.

But What If the Project Misses?

Here’s the flip side: if costs run over, rents come in low, or the market turns, the deal can unravel fast.

Let’s say the project ends up selling for only $35 million after 3 years.

• The $28 million loan still has to be repaid first

• That leaves just $7 million for the equity investors (LPs and GP)

In this scenario, there’s not enough money to return all the equity, let alone provide a preferred return.

Capital Invested:

• LPs: $10 million

• GP: $2 million

• Total equity: $12 million

• Available after debt: $7 million

Let’s assume the remaining $7 million is split pro rata based on capital invested (no promote, since preferred return wasn’t met):

• LPs receive 83.33% of $7M = $5.83 million

• GP receives 16.67% of $7M = $1.17 million

Investor Losses

Limited Partners (LPs)

• Total received: $5.83 million

• Equity multiple: 0.58x

• IRR: –16.8%

General Partner (GP)

• Total received: $1.17 million

• Equity multiple: 0.59x

• IRR: –16.4%

Even though the project generated some value, the investors lost money, and the developer didn’t earn a promote. This is the dark side of leverage: when a project underdelivers, it doesn’t just lower returns—it destroys them.

Why Yield on Cost Has to Beat Cap Rates

Developers know this: you can’t just build something and hope it sells for a profit. You have to build it to generate income—rental income—that makes the numbers work.

This is where yield on cost comes in.

Yield on cost = Net Operating Income (NOI) ÷ Total Project Cost
It’s the return the project generates based on what it cost to build.

Developers compare this to market cap rates, which are the returns investors expect when they buy stabilized buildings. To be worth the risk of building, the yield on cost needs to be meaningfully higher than the prevailing cap rate.

For example:

• If apartment buildings are trading at a 5% cap rate, a developer might need to build at a 6.5% yield on cost.

• That 150-basis point “spread” is the developer’s cushion—the margin that justifies the risk, the delays, the debt, and the uncertainty.

If that spread shrinks—say construction costs rise or rents come in lower than expected—the whole model can fall apart.

What This Means for Landowners

If you own land and are talking to a developer, understanding how they’re using leverage helps you see the risk they’re taking—and the value you may be sitting on.

A few takeaways:

• Developers use other people’s money to multiply their returns—but that also multiplies the risk.

• The more debt in the capital stack, the more sensitive the deal is to market shifts.

• Developers won’t touch a deal unless the yield on cost clears the hurdle.

• As a landowner, you’re in a position of power if your site helps a project hit that spread.

Leverage is powerful—but it cuts both ways. Knowing how it works is key to making smarter decisions about your land.

Want to understand what your land could be worth to a developer? Let’s talk.

Until next time,

John & Ramey