Commercial real estate is expensive and its prices are typically out of reach for all but the most well funded individual investors. As such, the funds to complete a commercial property purchase typically come from some combination of equity financing and debt financing. Equity could come from the individual borrower or equity investors who purchase common stock in the property’s operating entity. Debt could be obtained from bank loans or any other type of debt instrument and the interest rate on it is a major factor in the property’s total cost of capital.
Collectively, the debt and equity financing sources are commonly referred to as a property’s “Capital Stack” and each component comes with its own set of rules and requirements. To understand the key differences between debt and equity, it is first necessary to understand the Capital Stack concept itself.
What is the Capital Stack?
Again, when purchasing a property, there can be a number of different debt and equity financing options and, collectively, these sources are referred to as the “Capital Stack” or “Capital Structure.” Depending on the complexity of the transaction, the Capital Stack can consist of up to 4 components (illustrated in the diagram to the left):
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
The key to understanding the Capital Stack is to know that each component comes with its own set of rules and requirements and that an individual’s position in it drives the risk/return profile of the investment. To underscore this point, each component is described in detail below.
In most cases, the “Senior Debt” is the primary source of capital and it can account for up to 80% of the property’s purchase price. Often, it is held by a bank, real estate specific lender, or other financial institution and it is considered to be the least risky component because it is secured by a first position lien on the property (NOTE: In rare cases, it could be unsecured). This means that, in the event of a default, the senior debt holder has the ability to initiate the foreclosure process, take possession of the property, sell it, and use the proceeds to repay the balance of what they are owed. In the event of a bankruptcy, the Senior Debt holder is also first in line to be repaid.
For these reasons, the Senior Debt holder also receives the lowest return on their investment. It can vary by deal, but it usually corresponds to the interest rate (or cost of debt) charged on the loan, often in the 4% – 6% range.
In some transactions, there is a gap between the amount of Senior Debt that a lender is willing to advance and the amount of equity that the purchaser can raise. To fill this gap, there is a specialized type of debt known as “mezzanine debt” or “mezz debt,” that is secured, not by a lien on the property, but by a pledge of ownership interest in the LLC that owns the property.
In terms of risk, Mezzanine Debt carries slightly more than Senior Debt because the holder does not have a claim to the property and does not have the ability to initiate foreclosure in the event of a default. Their interest is “subordinate” to the Senior Debt holder and they are second in line to be repaid in the event of a bankruptcy. For these reasons, the Mezzanine Debt holder demands a higher return. Interest rates on Mezzanine Debt vary by lender, but can range from 6% to 12%.
Preferred Equity is not a loan. It is an investment in the entity that owns the property. As such, the Preferred Equity holder’s investment is not secured by the property itself, but by the cash flow produced by the ownership entity. Because of their “preferred” status, the holder is first in line to receive cash distributions once all debts have been satisfied. In a typical real estate transaction, this can manifest itself in the form of a “preferred return.”
From a risk standpoint, the Preferred Equity holder’s position carries more risk than the debt holders because they do not have a claim to the property and they are third in line to be repaid in the event of a bankruptcy. Because of this, the return expectations are such that the Preferred Equity holder demands some level of income; plus participation in the profits and/or capital gains achieved by the property.
The Common Equity shareholder is the most risky position in the Capital Stack and commands the highest return potential as a result. Their investment is also secured by equity shares in the ownership entity (which gives the shareholders voting rights), but it falls behind the Preferred Equity holder in terms of priority, making them last in line to be repaid in the event of a bankruptcy.
In a typical commercial real estate syndication, the Limited Partners are investing in the Common Equity position of the Capital Stack. Their return is paid from the cash flow and profits produced by the underlying real estate and there is no limit to their potential return. It is only constrained by the performance of the property.
The Capital Stack – Why it Matters
When financing a property, trying to find the right mix of debt vs equity can be complicated. To illustrate why it matters, consider the following simple example. Assume that a struggling property has $2.4M in outstanding Senior Debt and $600k owed to Common Equity shareholders ($3M total). After the property moves into foreclosure, the lender is forced into a distressed sale where they get $2.8M for it.
Because the Senior Debt holder is first in line for repayment, they will receive everything owed to them, $2.4M (includes interest payments). But, that only leaves $400k left to be paid to the Common Equity holders, who will receive only a fraction of their investment back.
Individuals considering a commercial real estate investment have the ability to invest in each component of the Capital Stack. In our case, the investment opportunities that we offer are in the Equity (Preferred or Common) component and it is important for individuals to be familiar with the rights, rules, and risk that come with it. Broadly, an equity investment carries more risk than debt, but the return potential is significantly higher.
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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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