Intro – The Capital Stack
If you’ve ever financed a single-family home purchase, you’re probably intimately familiar with the breakdown of debt and equity in your home. You secure a loan from a bank, put down initial capital, and build more equity over time as you repay your mortgage and your home appreciates. When it comes to commercial real estate transactions amounting to tens of millions of dollars, though, financing becomes more complicated – the difference between equity, preferred equity, mezzanine debt and senior debt can confuse even savvy investors.
The capital stack (or “cap stack”) for simple deals will be just equity and senior debt, while the most complicated may have multiple tranches of mezzanine debt or senior debt that is later syndicated out into multiple notes. For now, let’s focus on the four categories you’re most likely to encounter when investing in real estate through an online investment or crowdfunding platform, going from the least to most risky: senior debt, mezzanine debt, preferred equity, and common equity.
…is secured by a mortgage or deed of trust on the property itself, so if the borrower fails to pay the the lender can take title to the property. This greatly reduces risk on the principal invested because, at worst, the lender owns the property and will look to maximize value by selling the property or selling the non-performing loan. The “cost” of this lower level of risk is a lower yield on the money invested. To properly understand the risk involved, look at the loan-to-value (“LTV”) ratio of the loan – if the loan has a 60% LTV there is a lot more margin for error than an 85% LTV loan. It’s a simple analysis: in the worst case scenario, as the lender, you’d much rather end up owning the property at 60% of its value than 85%.
Whether a lender is willing to lend to a particular developer or investor – and at what rate – depends on a number of factors, including the borrower’s creditworthiness (which takes into account track record and DSCR among other factors); macro factors such as prevailing market interest rates; and the lender’s balance sheet. Large traditional lenders (banks) often move slowly, and are heavily regulated, creating opportunity for private “hard money” lenders, who issue loans at higher interest rates, typically over shorter terms. This, in turn, creates opportunity for us to source senior debt opportunities with experienced private lenders, lending to Sponsors with strong track records.
…sits below the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the fixed coupon of the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called an intercreditor agreement, where they spell out how their rights interact (i.e., what happens if a developer stops paying both of them). Mezzanine debt typically has a higher rate of return than senior debt but lower than equity.
…is perhaps the hardest portion of the capital stack to define generally because, for better and worse, it’s very flexible. It gets its name because preferred equity holders have a preferred right to payments over regular equity holders. In terms of other characteristics, they will range from “hard” preferred equity, which can be very similar to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or kick out the developer if they fail to make payments, soft preferred equity holders typically have more limited rights. As you’d imagine, the rate of return for hard preferred equity is similar (or slightly better) than mezzanine debt, while soft preferred equity returns can be substantially better.
For more on arrangements of equity and preferred equity, please see the prior article on distribution waterfalls.
…is the riskiest and most profitable portion of a real estate deal. Typically the developer (often called the sponsor) will be required – by the lender and/or by other equity investors – to invest their own money as some portion of the equity to have skin in the game. As an investor in equity your risk is the greatest because every other tranche of capital is entitled to get paid before you. However, if the property does well equity investors usually have no cap on their potential returns. In real estate, equity is typically structured so that all investors earn a preferred return until they hit a certain annual return hurdle (i.e., 8%). After that, the developer will earn a disproportionate share of the profits (i.e., 40% of all the remaining profit), while investors receive the rest of what’s left pro rata.
It’s worth noting that common equity deals investments typically entail a significantly longer hold period than senior debt or preferred equity investments (anywhere from 3 to 7 years). This is part and parcel of the greater risk inherent in common equity deals, and generally superior projected returns; common equity investors are compensated for lack of liquidity with higher projected equity multiples.
Understanding these different investment structures and how they impact both risk and return is a key step in making real estate part of your investment portfolio. Much like investing in stocks and bonds, how you allocate between equity and debt real estate investments should depend on your investment goals and strategy, including your risk tolerance. For risk-tolerant investors, heavier exposure to real estate equity may be more appealing. For risk-averse investors prioritizing wealth-preservation, secured debt investing may be more appealing. While studies repeatedly show that “timing the market” is next to impossible, even for experienced investors, timing considerations can also help guide portfolio strategy. After many years of a bull market, finding good value equity investment opportunities becomes more difficult, leading some investors to weight their portfolios towards debt, saving their equity investment dollars for situations where they have greater conviction. For most investors, a diversified approach makes sense both for the real estate portion of their portfolio and the portfolio as a whole.
As with other attributes of real estate investments (sub-asset class, market, strategy), diversification – spreading your real estate investment dollars across the capital stack – will provide downside protection, and can generate better aggregate returns over time. Investing in shorter-term senior debt deals and longer-term equity deals, with rolling maturities and varying cash-flow profiles, provides a hedge against short-term market fluctuations and provides consistent access to liquid capital so that you can more nimbly act on new investment opportunities.