A successful real estate deal requires more than just a great location and a solid business plan. A successful deal also includes a well-defined financing structure. Both investors and lenders can fund the project, however, each will have different levels of risk and return.
The capital stack shows how a real estate project will be financed, and the order in which each type of financing will be paid off.
Follow the Money
As a ladder, each step of a real estate development can represent a form of financing. Generally speaking, there is less risk associated with the lower steps of the ladder, but there is also a greater chance of increased risk (and possibly higher reward) as you go up.
Senior Debt: First in Line
Generally, the most significant portion of a loan to finance a real estate project will be considered senior debt. Senior debt is generally paid off first, before other forms of debt, and the lender’s collateral is the property.
Senior debt has a tendency to have a lower interest rate than junior debt due to the decreased amount of risk associated with lending to someone with a higher level of debt. The decision on whether or not to provide senior debt to a borrower is determined by the value of the property that will be financed, the borrower’s annual income, and the borrower’s ability to pay back the borrowed funds.
Mezzanine Financing: Supplementing the Senior Loan
Mezzanine financing can provide additional funds when a senior loan does not allow enough money to finish the project. The senior loan has higher priority than the mezzanine loan for repayment.
Because of the increased risk of making a loan to a borrower, mezzanine lenders generally charge higher interest rates. If the borrower does not repay his/her loan, then the mezzanine lender may be able to make certain claims against the owner of the property.
Preferred Equity: The First Choice of Capital for Investors
Preferred equity is a type of investment capital that can be paid off prior to common equity. Preferred equity is on the same level as both debt and common equity within an organization’s capital structure.
Its terms can differ. While some deals provide a preferred return, others may have additional rights or conditions.
Common Equity: Ownership With More Risk
Common equity is provided by the sponsor, and/or additional investors who have acquired ownership in the project. Typically, the common equity investor is paid after the project’s debt and preferred equity obligations are satisfied.
Common equity returns are dependent upon how successful the real estate investment is. If there are high levels of profitability from the real estate development then the common equity investor will be rewarded with the highest rate of return. However, if the real estate development loses value then the common equity investor will likely experience losses first.
A Simple Funding Example
A $5 million property might be funded with:
The total amount is the same as the purchase price. The exact ratio of each item used in the mix will vary depending upon the type of project, the rules established by the lender, and what the investors hope to achieve.
Why the Structure Matters
A good plan for your capital stack will help you to balance your funding needs, your cost to get the funding and your level of risk. However, with each additional dollar of debt you take on, you will be adding pressure to your ability to generate positive cash flow. Investors should know where they stand in terms of being repaid first (repayment priority), what fees are associated with the transaction, how returns are calculated and what would occur if the project falls short of its projected performance.
Before making an investment, examine the entire funding mechanism. Understanding what your money is invested in can give you insight into the potential risks associated with that investment as well as the potential return on investment.
