What is Common Equity In Common Real Estate?
In a typical commercial real estate transaction, 50% – 70% of the property’s purchase price is financed with debt (a loan). Depending on the specifics of the real estate deal, the difference between the purchase price and the amount of debt that a lender is willing to provide must be raised as “equity.” But, not all equity is created equal. Some deals may have preferred equity, common equity, or both.
In this article, common equity is defined and its features, pros, and cons are discussed in detail.
Common Equity and the Capital Stack
Common equity is one of four components of the “capital stack,” which is the collection of capital used to finance the purchase of a commercial real estate asset. The features of common equity include:
- Security: In most commercial real estate transactions, a limited liability company (LLC) is formed specifically for the purpose of the property. This company acts as the borrower in the loan transaction. To raise the funds needed to bridge the gap between the purchase price and the loan amount, shares of stock are sold in the LLC. As such, a common equity investment is not secured by an interest in the commercial real estate asset. It is secured by shares of stock in the company that owns the asset.
- Priority: In terms of repayment priority, common equity holders are last in line. This is particularly important in the case of bankruptcy or foreclosure because it means all other participants in the capital stack get repaid ahead of them. An example of this is illustrated below.
- Risk: Because common equity holders are last in line to be repaid, their position is considered to be the riskiest in the capital stack. As a result, common equity investors demand the highest return – to be compensated for this risk.
- Return: Herein lies the allure of common equity. To compensate for the risk involved with this tranche of the capital stack, the common equity position also has the opportunity to earn higher returns. In most cases, this higher rate of return on common equity comes as a result of a profit made on the sale of the commercial real estate property. There is no cap to common equity earnings, but the typical range is 15+% annually.
In a private equity firm sponsored commercial real estate transaction like the ones we offer, common equity holders may also be referred to as “Limited Partners” and their capital contribution is a critically important component of getting the transaction closed.
How is Common Equity Calculated?
The amount of common equity needed in a transaction is a function of the amount of debt that a lender is willing to provide, the purchase price, and the presence of preferred equity holders. To illustrate how this works, an example is helpful.
Suppose that a real estate investor is considering the purchase of a multifamily property with a purchase price of $10,000,000. The real estate investor has partnered with a lender who is willing to provide debt of $6,500,000. This means that the real estate investor needs to raise $3,500,000 in equity. This equity raise could consist entirely of common equity. Or, it could be split between preferred equity and common equity. This decision is made during the underwriting process and it is dependent upon the level of risk that an investor wants to take in the transaction.
Is Common Equity The Same as Total Equity?
No. Common equity is not the same as total equity. Within the capital stack, there are two types of equity – common and preferred. The key difference between the two is the repayment priority.
As the name suggests, preferred equity investors receive preference over common equity holders when it comes to repayment order. For this reason, preferred equity investments are considered to have less risk than common equity investments. As a result, their potential return on common equity is also lower.
In the example above, the commercial real estate investor needed to raise $3,500,000 in equity. As the example described, this could be split between preferred equity and common equity, which has distinctly different risk/return profiles and rights.
Pros and Cons of Investing In Common Equity
For individual commercial real estate investors, the primary benefit of allocating capital to common equity shares is the potential return. If a property performs well and is ultimately sold for a healthy profit, the potential upside can be lucrative.
But, that potential return on common equity comes with a higher level of risk, which is the primary downside of a common equity investment. To illustrate this point, consider the example above. If the real estate investor purchases a property for $10,000,000 and finances it with $6,500,000 in debt and $3,500,000 in common equity, it would seem to be a relatively safe risk profile. But, now suppose that the property was very poorly managed, vacancy increases, and the cash flow is no longer sufficient to make the required loan payments. The senior lender forecloses on the property and is forced to sell it for $7,000,000 in a down market.
In such a case, the senior debt holder will receive their $6,500,000 back. Once they do, there is only $500,000 left over for common equity holders, which means that they will lose most of their initial investment. For this reason, it is incredibly important for equity investors to perform a significant amount of due diligence on their transaction sponsors to ensure they will manage the property well through all phases of the economic life cycle.
Summary & Conclusions
Common Equity is one of four tranches of the commercial real estate investment capital stack. An investment in it is secured by shares of stock in the limited liability corporation formed to purchase the real estate property, not the property itself.
Common equity investors are last in line to be repaid in the event of a bankruptcy or foreclosure, which means their position carries the most risk in the capital stack. But, it also means that they have the highest return potential from the real estate because they are entitled to participation in a profitable sale.
Potential common equity real estate investors should perform a significant amount of due diligence on their transaction sponsor, the market, the capital structure, the tenants, operating expenses, and the location to ensure a common equity investment strategy is a good fit for their return objectives.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate (CRE) 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.