EquityMultiple Learning Series Part IV - Understanding the Capital Stack

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Modern Real Estate Investing Intro Series

Part IV. - Understanding the Capital Stack

© 2015 EquityMultiple, Inc. All rights reserved.

Every homeowner understands the difference between their

mortgage and the equity they have in their home but when it

comes to commercial real estate transactions, the difference

between equity, preferred equity, mezzanine debt and senior debt

can confuse even savvy investors. The simplest 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.

Intro

Combined Equity

Combined Debt

$0MM

$3MM

$6MM

Senior Debt

LEGEND

Mezzanine Debt Common Equity

Preferred 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%.

Senior Debt

Senior Debt


…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.

Mezzanine Debt

Mezzanine Debt


…is perhaps the hardest portion of the capital stack to speak

about generally because it’s, for better and worse, very

flexible. It gets it’s 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.

Preferred Equity

Preferred Equity


…is the riskiest and most profitable portion of a real

estate deal. Typically the developer (often called the

sponsor) will be required to invest 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.

Common Equity

If you’re new to commercial real estate investing, this is a lot to learn but once you

get past the jargon it all starts to make sense.

Common Equity


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 example, for risk tolerant investors, heavier exposure to real

estate equity may be more appealing. While studies repeatedly show that, even for

experienced investors, “timing the market” is next to impossible, timing

considerations can also help guide portfolio strategy. After many years of a bull

market, finding good value equity investment opportunities becomes more difficult

so some investors will be more inclined 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.


This introductory series aims to give you a solid grounding in investing through online real estate platforms - how to

best capitalize on this new world of access, and how to best protect yourself against risk. We hope you have found

this content beneficial. Please stay in touch and let us know how we can be of service as you embark on your

commercial real estate journey.

Questions? [email protected] the Platform:

www.equitymultiple.com

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EquityMultiple Learning Series Part IV - Understanding the Capital Stack