What is The Capital Stack in Real Estate Syndication?

When investing in apartment building syndications, passive investors need to understand the pecking order of payments, including who gets paid first, second, third, and fourth. The capital stack, which determines the order in which funds are paid in a commercial real estate investment, is crucial to understand. Preferred returns may sound like an exclusive status, but investors need to know where they fall in the order of priority for returns as there are debt obligations and preferred equity holders with priority over LPs. Being at the bottom of the capital stack may seem counterintuitive, but it puts investors in the first place to receive funds and offers greater stability with less risk. Understanding this concept is crucial for investors to know their position in the capital stack and make informed investment decisions. Analogy to the game Jenga can illustrate the importance of being at the bottom of the capital stack as it offers more stability with less risk.

In a multifamily property investment, the capital structure comprises several components, including senior debt, mezzanine debt, preferred equity, common equity, and sponsor equity. The debt/equity structure of a single deal can have multiple sources of capital. Generally, senior debt has the highest priority, followed by mezzanine debt, preferred equity, common equity, and sponsor equity. It is crucial to understand each of these components’ roles to know where you stand in the pecking order of returns.

Dissecting The components of The Capital Stack

Senior Debt: In real estate investments, senior debt is usually backed by a mortgage or a deed of trust on the property. If the borrower defaults on the loan, the lender can take possession of the property. This security feature reduces the risk for lenders since they can recover their investment by either selling the property or the non-performing loan.

Mezzanine Debt: Mezzanine debt serves as a bridge between debt and equity financing, making it less common than senior debt. It is a high-risk type of debt because it ranks below senior debt but above pure equity. Mezzanine debt usually takes the form of bridge loans or second mortgages and is subordinate to senior debt in terms of payment priority. It typically has preference over preferred equity when both are included in the capital stack, resulting in a lower return.

Preferred Equity: It is not uncommon for Limited Partners who have a “preferred return” to assume they hold preferred equity. However, even with a preferred return, they still fall under the category of common equity holders. Preferred equity investors, on the other hand, are less risky since they receive payments before common equity holders, making them a priority in receiving distributions.

Common Equity: At the top of the capital stack is the riskiest position, but it also offers a higher return. Equity investments carry the most significant risk because other tranches of capital are repaid before common equity holders. However, there is no limit to the potential return. In contrast, preferred equity is considered less risky than common equity, and investors in preferred equity have their upside capped.

Single and Dual Tier Capital Stacks

In real estate syndication, there are two types of capital stacks – single and dual-tier, and comprehending the payment structure of returns is crucial. Knowing about the risk and priority level of each tier is essential to align your investing goals and to understand the timing and amount of distributions you’ll receive.

Single-Tier Stack

In a single-tier capital stack, senior debt is situated at the top, carrying the lowest risk and holding the highest priority when it comes to payments. The senior debt is usually secured by a mortgage or a deed of trust on the property. If the borrower defaults on the loan, the lender can take title to the property, thus reducing the risk for the investor.

After the senior debt, comes the Common Equity – Class A preferred return. The Class A tier takes the preferred position below the senior debt, with less risk and a lower upside. The Class A investors receive a guaranteed COC% (cash-on-cash return), but it caps their returns, limiting their upside potential. If your goal is cash flow, Class A is a suitable option. Finally, the sponsor Equity – Class B tier is at the bottom of the stack, carrying the highest risk and lowest priority. The general partners have no preferred return and only receive their 30% promote from the 70/30 split if the property cash flow is greater than the preferred return of the Class A investors.

Dual-Tier Stack

In a dual-tier capital stack, Senior debt is placed in the top tier, followed by any subordinate debt such as mezzanine or bridge debt. These tiers have priority over equity investments and are considered the lowest risk levels of the stack. Senior debt is secured by a mortgage or deed of trust on the property, and in the event of default, the lender can take ownership of the property. Mezzanine debt is subordinate to senior debt but senior to pure equity and bridges the gap between debt and equity financing.

The second tier of the capital stack consists of preferred and common equity investments. The Class A preferred equity level receives projected cash flow at a preferred return only and is ideal for investors seeking consistent cash flow distributions. The Class A preferred equity investment level typically requires a more substantial up-front investment with limited shares available. The Class B common equity level offers preferred returns, splits beyond the preferred percentage, and capital returns participation. Investors seeking capital appreciation may opt for the Class B common equity investment, which may provide a lower passive income during the holding period but allow participation in all the upside.

The last level in a dual-tier capital stack is Sponsor Equity, which carries the highest risk and lowest returns because it receives cash flow after all other tiers. Sponsor Equity investors receive their 30% promote only if the property cash flows are greater than the preferred return of the Class A investors. The waterfall distribution model dictates how profits and losses are distributed among investors in a syndication deal. As such, understanding the tier structure and priority at each level is crucial to understanding when and why you will receive distributions in a real estate syndication.

The Waterfall

After paying off the debt, a waterfall system is employed to allocate the funds based on the return thresholds outlined in the A/B hierarchy. In a hypothetical scenario, a portion of preferred private equity may be positioned behind the debt, and the waterfall will spill down to the common equity group of investors once a 10% return is achieved. The pref equity may be restricted to a 10% preferred return, which could limit cash flows to common equity during the holding period, and they may not be allowed to participate in the upside, which is similar to the A shares and B shares tier structure.

Each real estate syndication deal’s PPM contains a waterfall structure that explains how, when, and who gets paid during the deal. It is important to note that any common equity or preferred equity partner is not in a debt position. Additionally, partners receive cash flow distributions after expenses, fees, and property debt payments.

Investors Need to Understand the Consequences of The Capital Stack

Investors should conduct proper research on the capital stack and its potential impact on their investments. They must determine if they are willing to assume the risk of being placed higher in the capital stack and potentially reap greater financial benefits.

The capital stack can impact investors in three significant ways:

• Cash on cash

• IRR

• Velocity

Cash on cash returns refer to the income an investor receives on their invested capital before taxes, also known as cash flow or distributions. If an investor is part of the preferred A-tier, they may receive more significant cash on cash returns. Preferred investors are paid first as they have a higher priority in the capital stack. Understanding cash on cash returns is crucial as it can affect an investor’s decision on which investment tier to choose.

The Internal Rate of Return (IRR) is a metric that measures the profitability of a real estate syndication deal, including cash and equity. It takes into account the time value of money, meaning that money received today is worth more than money received in the future. The IRR can help investors compare different investment opportunities and assess which deals are more profitable in the long term.

Velocity refers to an investor’s ability to invest in more deals at a faster rate. When a deal is refinanced, an investor in the B tier or common equity may receive some capital back, which can be used to invest in another project. This approach helps investors get returns on multiple real estate syndication deals, even though they only had the money to invest in one deal initially. Understanding velocity is essential as it can help investors grow their wealth by combining capital appreciation and multiplication.

By comprehending these concepts, investors can make better investment decisions and align their investments with their personal financial goals. It’s essential to understand the risks and priorities associated with each tier in the capital stack, the potential cash on cash returns, the profitability of the deal, and the ability to invest in multiple deals to achieve financial success.

Conclusion

Real estate investment involves many areas to understand, and the capital stack is one of them. It determines the priority of payouts to investors based on their investment tiers, and the waterfall schedule outlines the payment sequence in each tier. The PPM provides all the details of the capital stack and waterfall schedule for potential investors to review before investing in the deal.

Understanding the nuances of the capital stack and waterfall schedule is crucial before investing in a real estate syndication deal. By comprehending how the capital stack works, investors can determine their priority level for distributions and understand the level of risk they are undertaking. With this knowledge, potential investors can make informed decisions about investing in a deal that aligns with their financial goals.

By reading and analyzing the PPM, investors can identify where they fall in the distribution hierarchy and which investment tier provides the best fit for their investment objectives. For example, investors seeking capital appreciation might prefer to invest in higher risk, higher return investment tiers, whereas those seeking lower risk and solid returns might opt for lower tiers with more consistent cash flows.

At Onbridge Capital, we offer investment opportunities that cater to a wide range of investor preferences. By signing up for our club, you can gain exclusive access to our upcoming deals and find the right investment opportunity that matches your investment goals and priorities. If you have any questions about the capital stack or any other real estate-related topics, we are happy to help and provide you with the information you need to make informed investment decisions.

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