Posted 2 months ago

How are Commercial Real Estate Investments Funded?

Capital Stack

Passive investors should understand the basics of how an investment is funded as capital from different sources is brought together to finance a real estate opportunity. Not all capital invested in an opportunity is equal in terms of the risks and returns. The graphic depiction of the full capital stack on a real estate investment is shown below. The stack represents an inverse hierarchy of risk and priority to receive payment. The higher the position on the stack, the higher the risk and expected returns, but the lower priority to collect profits and income generated by the asset.

Normal 1608498203 Cap St

Senior debt occupies the bottom position because its interests are secured by the asset, which serves as collateral for the loan. Senior debt is considered to have the lowest risk because of its secured position. In addition, due to its “senior” position, it receives a predetermined return before the higher positions in the stack. In the event of default, the senior debt holders have the right to foreclose, assume ownership, and liquidate the asset to recover capital owed.

Mezzanine debt is subordinate to senior debt but ordinate to all equity positions. This debt is unsecured, but if the debt payments are not made, the lender may assume the ownership interest of the sponsor. This debt demands a higher return than senior debt and is a “hybrid” position in that it may share in some of the profits.

The senior lender and mezzanine lender will usually enter into an agreement, called an inter-creditor agreement, where the lenders outline how they will proceed if debt payments are not carried out.

Preferred equity is subordinate to mezzanine debt and ordinate to common equity positions. This equity position is paid ahead of common equity but has lower risk and expected returns than common equity. Similar to mezzanine debt, this position is a “hybrid” in that it may have limited potential for additional compensation.

Common equity is at the top of the stack and has the most risk of all the positions because these equity holders are paid only after all the others are paid. These holders are not guaranteed to receive either income or invested capital but have the potential to make the highest return of all the positions to compensate for their investment risk. Each position carries a distinct risk-to-reward profile, and all these positions come together to finance an opportunity.

Most passive investors that invest in a syndicated real estate opportunity will be in the common equity position. For equity holders, their return will be variable and dependent on the success of the project. Distributions from operations and profits from liquidity events (refinance or sale) are “split” among the equity holders (i.e., the sponsor and the passive investors). A common split is 70/75% to the passive investors and 30/25% to the sponsor, but the exact percentage split varies among opportunities. Furthermore, there may be one or more hurdles (or waterfall) whereby the split may increase in favor of the sponsor if a pre-determined performance metric is achieved. For instance, the split may change from a 70/30 to a 60/40 split once the project achieves a specified return.

Financial Performance Metrics

Many financial performance metrics are used to evaluate an investment and derived from a property pro forma. The pro forma is a simplified and combined income and cash flow statement of the property projected into the future. The pro forma accounts for financials such as revenue, operating expenses, capital expenditures, and debt service, which allow financial metrics to be determined. Passive investors should keep in mind that the projections in the pro forma are based on assumptions made by the sponsor.

These assumptions should be based on a combination of past market performance, existing market characteristics, and future trends. The conservative or aggressive nature of these assumptions reveals the credibility of the metrics. Recall that for a value-add strategy, the goal is to reposition or force appreciation on the asset. Appreciation may be forced either by increasing income, decreasing expenses, or both, with the ultimate goal of increasing the NOI.

Normal 1608498232 Cap St 2

Take Away for Investors

Financial metrics and their underlying assumptions are necessary to know, but investors should consider that not all returns are created equally. A “higher” quality return is primarily based on passive income with associated passive losses to reduce tax liability. A “lower” quality return is based primarily on appreciation and principal pay down. With a stabilized income-generating asset, the passive income is generally very consistent, whereas appreciation and principal pay down can be realized only upon a liquidity event. Appreciation generally bears the bulk of investor returns but is the least predictable.

For more information on commercial real estate and passive investing in multifamily assets, please check out our eBook — More Doors, More Profits — by clicking here.