Capital Investment Balances Risk and Reward
Investors commit capital (typically, but not always, cash money) to an enterprise in return for a bundle of rights entitling them to reap financial fruits (or “proceeds”) of the business. Most businesses get their capital from two broad types of investors: equity and debt. Generally speaking, equity capital is more at risk than debt capital because equity holders usually have no absolute right to repayment of their investment principal. Concomitantly, equity investors enjoy a greater potential upside (through the profits of the business and appreciation of their ownership interests) than debt investors (who receive, at the most basic level, repayment of principal plus a rate of return). Within each broad category of investors, many sub-categories can also exist, such as preferred and common equity, and senior and junior debt. Even these sub-categories can break further into sub-sub-categories, according to a multitude of distinctions among them (e.g., secured/unsecured debt, limited/general partners, conversion rights, and so on).
Visualizing Business Investment Capital as a “Stack”
Business and finance people usually conceptualize the classes of capital investors in business as a “stack”, “structure”, “layer cake”, one class sitting atop another, their relative positions defined by the bundle of rights they received in exchange for their investments. At risk of oversimplifying, the most foundational distinction between these layers is the priority an investor in one class has to receive proceeds from the operations or assets of the business, relative to priority to receive those proceeds of an investor in a different class. (Not to mix metaphors, but you may also sometimes hear this relative priority of investor classes referred-to as a “waterfall“, the “water” being the proceeds of the enterprise, and the layers of the stack reflecting who collects the “water” first, second, third, and so-on.)
The CRE Investment Entity Capital Stack
With those preliminaries out of the way, let’s take a look at the typical capital stack of a real estate investment entity, which most commonly takes the form of a limited liability company (LLC) or a limited partnership (LP) formed to own and operate a single real estate asset.
In our visualizations of a CRE company capital stack, we prefer to depict the highest priority capital investors at the top of the stack, which reflects their right to drink first from the CRE asset’s “waterfall” of proceeds. Keep in mind that each distinct layer shown below represents a means by which capital “flows into” the business. Their relative position to each other reflects, in essence, the order in which investors in those layers get paid a return, and on what terms.
- Senior secured debt- This capital stack category is akin to a typical home mortgage loan. A lender (usually, but not always, a bank) commits capital (usually, but not always, to finance a property purchase) in exchange for the enterprise’s agreement to repay principal and interest on an agreed schedule at an agreed rate. To ensure repayment, the lender takes a security interest in business collateral (again usually, but not always, the real estate asset purchased with the loan principal). Senior secured debt is the “safest” way to invest in a CRE company but also yields the most conservative returns.
- Junior (or “mezzanine”, or “subordinated”) debt- Junior debt, sometimes called “mezzanine” (or just “mezz”) debt after its position in the relative middle of the stack, takes a variety of forms. Similar to senior secured debt, it is a loan. However, junior/mezz lenders usually agree to the repayment of their loans only out of business proceeds that are left after the senior debt holders get paid. In exchange for this “subordinate” position to the senior debt, junior lenders often (but not always) receive a higher rate of interest on their principal, a security interest in a specific business asset, rights to convert their debt into equity, and/or some other favorable term that makes committing capital worth their while. Investing in a CRE enterprise as a junior or mezzanine lender is generally safer than taking an equity stake (because it still comes with a promise to repay principal), but not as safe as lending on a fully-secured basis (because of its subordinate position).
- Equity. Investors in the equity of a CRE business exchange their capital for ownership interests that entitle them to specific rights. What we call those interests depends on the entity’s business form: “stock” or “shares” (in a corporation); “units” or “membership interests” (in an LLC); “partnership interests” (in an LP). An agreement, supplemented by the corporate law of the state where the entity was formed and by state and federal tax laws, typically defines the rights of these equity holders. Those rights vary depending upon market realities and business needs, but they virtually always cover at least three fundamental matters: voting on/participating in management of the enterprise; sharing in the profits and losses (including tax benefits) of the enterprise; and selling, pledging, or otherwise monetizing ownership interests. Unlike debt holders, equity investors rarely have an absolute right to demand repayment of their investment capital from the proceeds of the business. Instead, they hope to recover it (and more) through a sale of their interest or a business liquidity event (usually, the ultimate sale of the underlying CRE asset).
The capital stack described above reflects a straightforward version of a CRE capital structure. Believe it or not, some capital stacks get even more complex. Investors sometimes marvel at the legwork we put into structuring the capital of our CRE investments to maximize potential returns and tax benefits. It takes skill and sophistication to get right, but that hard work often pays significant dividends.
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