- The “capital stack” is the collection of capital used to finance the purchase of a commercial property. Broadly, it consists of two components, debt and equity.
- Debt is the money provided by a lender and usually accounts for 50% – 75% of the property’s purchase price. The difference between the debt amount and the purchase price is known as equity..
- The benefits of investing in equity include preferred returns, tax advantages, profit participation, and the ability to force a property to appreciate.
- The cons include: lack of liquidity, additional risk, fees, and subordination to debt holders.
- For commercial real estate investors comfortable with the risk/return profile of an equity investment, they have a number of commercial real estate investment options including REITs and private equity.
Within the realm of commercial real estate investing, there are a wide variety of opportunities for investors to gain exposure to this asset class. One of those opportunities, equity investing, is highlighted below.
The goal of this article is to define exactly what an equity investment is, identify where it fits in a property’s “capital stack,” discuss the return metrics used to measure its success, and describe its pros and cons. By the end of the article, readers should have all of the information they need to determine if an equity investment is a good fit for their real estate investment objectives and individual preferences.
At First National Realty Partners, we offer equity investment opportunities through individually syndicated private equity deals. To learn more about our current investment offerings, click here.
Real Estate Equity Investments
The most logical starting point for a discussion on commercial real estate equity investment opportunities is with a discussion of the “capital stack.”
What is the Capital Stack?
In a real estate investment, the term “Capital Stack” is used to refer to the collection of capital that is used to finance the purchase of a commercial property.
Although the capital stack can contain several tranches, the scope of the discussion for this article is limited to just two: debt and equity.
Debt is the loan that is received from a bank or real estate lender and it typically makes up between 60% and 80% of a commercial property’s purchase price. Debt is secured by a first position lien on the property, which means that debt holders are first in line to be repaid. As a result, this “senior” position is considered to be relatively safe.
Equity is the amount of money that makes up the difference between the property’s purchase price and the amount of debt that a lender is willing to provide. For example, if a property had a purchase price of $10,000,000 and the lender provided a loan of $7,500,000, the equity needed to complete the transaction is $2,500,000.
Equity investments are secured by shares of stock in the limited liability corporation (LLC) that owns the property and they are “subordinate” to the debt holder. This means that equity investors get paid behind debt investors. For an average commercial property, this means that equity holders are entitled to whatever money is left after all of a property’s operating expenses and loan payments are taken care of. For this reason, the equity position is considered to be slightly more risky, but it also offers the potential for a higher return.
Pros and Cons of Equity Investment
For individuals considering an equity investment, the following pros and cons should be considered.
Pros of Equity Investment
Although there are many benefits to a commercial real estate equity investment, we want to highlight four in this article:
- Preferred Return: In the types of commercial real estate investments that we offer, equity investors are often given a preferred return to incentivize them to contribute. This means that they receive a return on their investment before the investment manager.
- Tax Benefits: Private equity investments allow for tax benefits. The corporate structure used to purchase commercial real estate investment properties is considered to be a “pass through” entity, which means that all expenses are booked at the entity level and the remaining income is passed on to individual equity investors. This lowers the amount of taxable income for the property, which means that individuals ultimately end up with a lower tax liability.
- Returns: While equity investors receive regular dividend payments, the largest portion of their return typically comes from participation in the gains on sale. When these two return components are combined, they can result in a high annual return.
- “Forced” Appreciation: The value of a commercial property is driven by the amount of net operating income that it produces. As a result, investment managers can pursue value-add projects that seek to increase income, decrease expenses, or both. In doing so, they can “force” the value of the property to appreciate, which results in better overall returns.
While these benefits are significant, it is also important that real estate investors consider the potential downsides to an equity investment.
Cons of Equity Investment
There are also four cons of an equity investment that are important for commercial real estate investors to be aware of:
- Preference: Equity investors only get paid with whatever money is left over after debt investors have received their share. This distinction is particularly important in the event of a bankruptcy or foreclosure event. For example, assume that a property has a $5,000,000 loan balance and $2,000,000 is owed to equity holders. If this property falls into bankruptcy and is sold in liquidation for $6,000,000, the debt holder would receive all of their money back and the equity holders would only receive 50 cents on the dollar for their investment.
- Liquidity: An equity investment made in a private equity commercial real estate deal or with a private REIT is not liquid. It often requires real estate investors to make a 5 or 10 year commitment, during which time they do not have access to their capital. If they have a financial emergency, they may be able to access it, but would likely have to sell their shares at a material discount.
- Access: Certain types of equity investments are only available to Accredited Investors who meet certain income and net worth requirements.
- Fees: Private equity and private real estate investment trust (REIT) managers charge fees for their services. Although the exact fees vary by deal, they can impact the net return received by equity investors.
Equity Investments vs. Debt Investments
If real estate investors don’t like the risk/return profile of an equity investment, they can opt to invest in the “debt” portion of the capital stack. The easiest and most accessible way to do this is to invest in a mortgage REIT or “mREIT” which is a company that finances real estate deals. However, it is important to note that the interest rates charged on mortgage REIT loans may vary by the strength of the borrower, the property type and real estate market, which can impact a real estate investor’s return. For example, the interest rate on a multifamily loan is likely to be lower than a loan for an office building because it tends to be less risky.
As discussed above, the major benefit of a debt investment is that holders are first in line for repayment and they have the ability to initiate foreclosure proceedings in the event of default. This offers relative safety, but it also means that the return tends to be lower. For perspective, an equity investment typically returns 8% – 12% annually or more, whereas a debt investment return is more likely to be in the 4% – 6% range annually.
Private Equity Commercial Real Estate Investment Firms
For individuals who are comfortable with the risk/return profile of an equity investment, there are several ways to make one.
First, equity REITs offer an easy, accessible way for investors to access commercial real estate equity through publicly traded stock exchanges. While they provide a high degree of liquidity, they can also be subject to short-term price volatility.
Or, another way that real estate investors can access equity investments is through a private equity firm. In this case, they must qualify as an Accredited Investor, but if they do, they can invest in private equity funds or deals. The benefit of this approach is that investors can leverage the experience, expertise, and professional networks of private equity firms to gain access to deals that would be otherwise unavailable to them individually. The downside of this approach is that private investments can be less liquid and require time commitments of 5-10 years.
Private equity investments can be made into a “blind fund” which pools investment capital for general purposes and deploys it as the investment manager sees fit. Or, they can be made in a single deal. In our case, we offer individually syndicated private equity deals, which allow investors to perform their own due diligence on the property, location, tenants, and market. We believe that this option is superior to a fund investment and have made it a cornerstone of our business strategy.
Summary & Conclusion
In a commercial real estate deal, the “capital stack” is the collection of capital used to finance the purchase of a commercial property. Broadly, it consists of two components, debt and equity.
The equity portion consists of the difference between debt and the purchase price. The benefits of investing in equity include preferred returns, tax advantages, profit participation, and the ability to force a property to appreciate. The cons include: lack of liquidity, additional risk, fees, and subordination to debt holders.
For commercial real estate investors that are comfortable with the risk/return profile of an equity investment, they have a number of investment options including REITs and private equity. For those who prefer the safety of debt, they could also invest in a debt focused REIT or private equity fund.
Either way, it is important that real estate investors perform their own due diligence to understand every aspect of an investment opportunity to ensure it is a suitable fit for their own preferences.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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