Here’s an insightful post by CrowdStreet explaining the capital stack and the difference between debt versus equity investing in commercial real estate. CrowdStreet is a leading real estate crowdfunding platform focused mostly on secondary cities with lower valuations and higher cap rates.
Most individual investors tend to buy physical real estate and hope the equity in our property grows over time. We tend to take all the risk and bear all of the reward or failure. However, if you are more risk-averse, you may want to invest in real estate debt instead. In other words, you can act more like the lender to make a return.
Where you invest on the capital stack matters with regards to when and how you get paid. Let’s take a deeper dive into debt versus equity investing in real estate. I’ll then share some concluding thoughts.
Investing In Real Estate Debt
At the most basic level, “debt” involves borrowing money to be repaid (getting a loan from a lender), plus interest, while “equity” involves raising money by selling interests in the company.
As a debt investor in a real estate investment opportunity, you’re acting as a lender to the sponsor behind the deal, much like a bank lent you some of the funds necessary to purchase your house. The loan is secured by the property itself. As a debt investor, you’ll generally receive a fixed rate of return, usually monthly, which is determined by the interest rate and how much you invested.
Debtors are obligated to pay back the creditors (i.e., the lender or debt investor) regardless of how much income the property is generating. It’s just like you still would owe the mortgage payment on a rental house even if you have no tenants.
These types of real estate investments are generally the least risky, but also generate the lowest returns. In the event that the sponsor defaults on their loan, debt investors typically have the ability to seek to recoup the loss of their investment through a foreclosure action. In some cases, the debt investors may have other means of recourse in the event of nonpayment, like corporate or personal guarantees.
Investing In Real Estate Equity
Equity investors, on the other hand, are essentially shareholders in a specific property and your stake is proportionate to the amount you invested. Most online real estate investing platforms give individual investors the chance to become equity investors.
The sponsors behind those deals are often looking to raise millions in equity from investors. Returns are then realized as a share of the rental income the property generates or a share of any appreciation value if/when the property sells. The riskier the project, the bigger the targeted returns to equity investors.
Understanding The Capital Stack
The whole point of investing is to earn returns in a risk-appropriate way. When it comes to private equity investing in real estate (going directly to the sponsor and not into a public REIT), the kind of investor you are determines when you get paid.
Much like Maslow’s hierarchy of needs, there is a hierarchy in a private equity capital structure that determines the order of distributions.
The higher you as an investor sit in the capital stack (the equity positions), the less likely it is for you to receive distributions. The probability of receiving distributions at the higher positions in the capital stack can also vary dramatically.
A capital stack has a priority of payment as follows:
Here is how investors in each layer of the capital stack receive distributions. This is a key component when considering debt versus equity investing in real estate.
Receiving Distributions As A Debt Investor
Senior Debt: The most senior of all forms of capital in the stack, senior debt is typically paid monthly or else the borrower risks going into “default” and senior debt holders can seize control of the asset and/or seek recourse from the borrower.
Senior debt has to get paid regardless of how much income the property is generating. Because it’s repaid first, senior debt usually receives the lowest returns relative to the other layers of the stack. But it typically has the greatest certainty of income. For most business plans, this is the safest spot to invest.
Mezzanine Debt: While still debt (meaning the borrower has an obligation to repay it), this form of debt is subordinate to senior debt. Its interest is paid only after the senior debt receives its interest payments. Mezzanine debt, however, must be paid prior to any other equity distributions. Targeted returns for mezzanine debt vary depending upon the level of leverage and risk involved in the deal.
In cases where the capital stack includes both mezzanine debt and preferred equity, mezzanine debt typically carries payment priority over preferred equity and consequently offers a lower rate.
Receiving Distributions As A Equity Investor
Most online real estate investing options available to individual investors on platforms like CrowdStreet fall into one of the following equity categories:
Preferred Equity: Preferred equity is not considered “debt,” which means there is no longer an obligation of the borrower to repay it. Preferred equity investors receive their share of distributions once debt service is paid but before payment is made to common equity investors
Common Equity: The top layer of the capital stack, distributions to these investors come after debt service (both senior and subordinate) is paid, preferred returns to preferred equity investors are paid (if they exist), and any reserves are funded for ongoing capital expenses. It’s important to remember that distributions to investors in the common equity layer are made at the sole discretion of the sponsor.
Here is the capital stack flipped upside down from lowest risk to highest risk.
Why Do Real Estate Developers Need Investor Equity?
One word. Leverage.
Leverage is the total amount of debt financing on a property relative to its current market value. It includes all of the different layers of debt in the capital stack. Real estate owners and developers often rely on leverage as a means of increasing the potential return on investment.
Two Examples With Different Return Outcomes
Let’s say a sponsor has $1 million in equity to invest, and they put 50% leverage on a property. This structure allows them to buy a $2 million retail building ($1 million in equity and $1 million in loans). They could either put up the full $1 million in equity themselves or raise $500,000 from individual equity investors. If the sponsor raises money, they are only investing $500,000 of their own capital into the project.
Alternatively, the sponsor could also use that same $1 million ($500,000 in investor equity and $500,000 of their own) and might decide to use 75% leverage to buy a $4 million office building. From a capital stack perspective the two deals look like this:
Greater Returns With Greater Leverage
Let’s says that in the first year both properties appreciated by 10% and the sponsors decided to sell.
Even though the two sponsors had the same amount of equity to start and both experienced the same percentage of property appreciation, the first sponsor makes a gross profit of $200,000 (sale price of $2,200,000 minus original $2,000,000) on the transaction. That is split 50/50 between them and their investor base, meaning they ultimately earned $100,000 on the project. A $100,000 return on $500,000 invested is a 20% gross return before fees.
Meanwhile, the second sponsor made a gross profit of $400,000 (sale price of $4,400,000 minus original $4,000,000), which they split with their investor base, netting them $200,000 for the same initial investment. A $200,000 return on $500,000 invested is a 40% gross return before fees.
In simple terms, leverage enables sponsors and investors to get a higher return in a successful deal. Of course, if a deal does not work out, leverage works in the opposite direction. Higher leverage translates to higher risk.
Equity Steps In When Debt Lending Slows Down
When the market shifted and property values dropped during the Great Recession, borrowers found themselves underwater right at the point their debt matured. They still owed that $3 million but the building might have only been worth $2 million, instead of the original $4 million they bought it for.
The subsequent deleveraging of commercial real estate in the aftermath of the downturn created a need for higher percentages of equity in capital formation. Simply put, if banks were less willing to loan or not willing to loan as much, sponsors needed to raise more equity from investors. This shift to the use of greater amounts of equity helped propel growth for real estate investing platforms such as CrowdStreet.
When COVID first hit, a lot of institutions pulled back on their lending, allowing individual investors to fill those gaps. CrowdStreet actually had its best year on record in 2020, with thousands of investors ultimately investing over $600 million into the real estate deals on its platform. Post-pandemic, it will be interesting to see how the lenders act and how lending standards will affect sponsors and investors alike.
Skin In The Game Matters
During a real estate bull market, we tend to want to have as much equity exposure as possible to potentially earn the greatest return possible. However, I encourage everyone to stay disciplined and focus on your financial objectives. Run the numbers to account for multiple scenarios (good, normal, bad).
An equity IRR target of 15% sounds very attractive compared to a debt IRR target of 7% over a five-year period. However, ask yourself what are the chances the property isn’t sold for a profit? If the property is sold at close to cost in the future, the equity IRR may be 0% while the debt IRR may be 7%. If the property is sold at a 20% loss, equity investors could get wiped out depending on the amount of leverage.
Ideally, you want to invest in a deal where the sponsor has as much skin in the game as possible.
In the above example, if the sponsor only invested $100,000 of its own money and raised $900,000 in equity and $1 million in debt to buy a $2 million property, I’d probably pass. However, if the sponsor put up $500,000 of its own money and raised $500,000 in equity and $1 million in debt for a $2 million acquisition, I’d feel much more comfortable.
After all, if banks want borrowers to put 20% down before qualifying for a loan, shouldn’t we investors demand the same from our sponsors? I think so.
I would like to thank CrowdStreet for explaining debt versus equity investing in real estate. You can sign up here and explore all the deals CrowdStreet has on its platform. The demographic trends towards lower-cost areas of the country is accelerating. Take advantage.
CrowdStreet is a content partner of Financial Samurai.
This article was written by an employee of CrowdStreet, Inc. (“CrowdStreet”) and has been prepared solely for informational purposes. CrowdStreet is not a registered broker-dealer or investment adviser. Nothing herein should be construed as an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. The Capital Stack is a FS original post.