Understanding The Capital Stack In A Real Estate Syndication Deal
The order in which distributions are paid out in real estate syndication investment opportunities is called the capital stack, and your understanding of how potential investors are paid is critical because you will want to know where you are positioned for your returns in the capital structure.
For example, if you invest in an apartment building and come into the deal structure at a Class B level with a Preferred Return, you will want to know why Class A investors receive distributions first, right?
Understanding how the waterfall structure is on any given deal determines the distributions in a real estate syndication will also provide you with the information you need as passive investors to better choose equity investments in which the capital stack is favorable toward your investing goals. The important thing to remember is that your knowledge of the risk and the priority at each tier and the return hurdles are vital in helping you to know why and when you’ll receive distributions.
This article will discuss what the capital stack is, why it’s essential to common equity holders, and how it impacts individual investors.
The way distributions are paid out in the capital stack is called a waterfall structure. Imagine all of the real estate investors participating in the multifamily syndication with the debt investors and the preferred equity partners categorized into groups. The group of investors who will receive the lower returns and have the highest risk is at the top of the capital stack. When cash flow is available, it gets distributed like a waterfall, starting at the top and trickling down to those with higher returns and a lower level of risk toward the bottom of the capital stack.
The waterfall structure is outlined in every PPM (Private Place Memorandum) that is provided to the investors prior to participation in any commercial real estate investment. These private placements will clarify who, how, and when each of the partners (both the general partners and the limited partners) will receive distributions during the hold term of the commercial real estate deal.
The Tier Structure
Some tiers within the structure receive only cash flow, while in other tiers the investors receive both cash flow distributions and a portion of profits from the capital returns upon the sale or refinance of the asset. So, you will want to understand which tier in the waterfall structure you would be in with your potential investment and how this would help you reach your investment goals.
- Are you mostly focused on receiving passive income on a monthly or quarterly basis?
- Or are you primarily wanting a larger lump sum return from the appreciation (both forced and market-driven) when the property sells?
- Or are you looking for a combination of both – a little support in the cash flow department plus some longer-term larger gains to help increase your net worth?
As we explore the various waterfall structures and capital stack tiers, always remember that any of the common equity investors as well as the preferred equity investors are not in a position of debt. Also keep in mind that cash flow distributions are always paid out to partners after the expenses, any fees, and any required debt is paid out first.
The capital stack affects investors in three main ways:
- Cash on cash
Cash on cash returns is the earnings an investor makes on their invested capital (before taxes), also referred to as the cash flow or distributions. If you’re in the preferred return tier, you may receive a higher rate of return because preferred investors have a higher priority, and thus will be paid first.
IRR means Internal Rate of Return and is a metric to measure the deal’s profitability (cash and equity). It’s a fancy way of calculating your return while accounting for the time value of money, a concept that holds today’s money more valuable to you than that returned to you in the future.
Velocity is essentially how fast you can turn your investment around and invest in more deals at a faster rate. So for example, when a multifamily syndication deal gets refinanced, you may get some of your capital returned if you’re participating in a capital returns position (not everyone gets their capital back – more on that in a minute). You can then reinvest that capital that you have received earlier than projected and invest in another opportunity. The more velocity you have in real estate syndication opportunities the more returns you can effectively receive by being able to invest in more deals.
When you understand these concepts and how each position in the waterfall or capital stack will impact each class, then you’re able to make better investment decisions to support your personal financial goals and achieve those goals faster.
The Capital Stack
With real estate investing you are wise to conduct your own research on the property, thoroughly vet the sponsor team and operators, and you will want to have an understanding of the capital stack and timelines for the payouts on the structure.
So, let’s talk a bit about how the capital stack itself is structured. The capital stack in a commercial real estate syndication investment is best described as a way that debt and equity partners are ranked in order based on an inverse relationship between risk and priority. What that means is that the highest priority investor partners with the lowest risk are toward the top of the capital stack while the lower priority, higher-risk investor partners are toward the bottom of the capital stack.
At the top, you’ll always have what we call Senior Debt which is typically the lenders who have the mortgages and loans that are needed to finance the property. The senior debt is the highest priority, and they get paid first. Mortgage-type loans typically have a lower rate of return in exchange for being the top priority.
The Next Tier in The Capital Stack
The next tier is what we call the mezzanine-type loans such as a second mortgage or a bridge loan. These too are debt positions and therefore will be placed at a higher priority and lower risk than our limited partner and general partner investors.
As we move through the tiers of the waterfall, next there will typically be preferred equity (limited) partners in the capital stack structure. Their priority is positioned after debt payments but before the general partners are paid. After the mortgage on the property as well as the expenses and fees are all paid, then preferred investors receive their distributions. Investors who are in this preferred return tier may have a higher investment requirement and the positions are limited at this tier level. It is usually the case, however that the preferred investors also often have a higher projected return than other investors further down the waterfall structure.
The next tier that falls below the Preferred Equity Partners is the Common Equity Partners or the general partners who are typically the sponsor team and the operators. This tier comes with the highest risk and the lowest priority. These investors are likely participating in capital returns and cash flow distributions but they are not paid until the Preferred Equity Partners are paid out first. The preferred level typically will receive a split of earnings up to a certain percentage of the cash flow.
There are two main types of capital stacks – single and dual-tier. Not surprisingly, the dual-stack is a little more complicated.
In a typical single-tier stack, Senior Debt is at the top, which will have the lowest risk and the highest priority. Let’s take an example of a mortgage with a 70% loan-to-value ratio.
Then you’ll see the Common Equity – Class A preferred return below the senior debt carrying a little higher risk and a slightly less priority. This is typically the limited partnership level in a single stack, which may be earning say a 7-8% preferred return with a 70/30 split beyond that. These limited partners (you) will likely participate in the capital returns and would share in the profits after the property is sold as well.
The last level in a single-tier stack is Common Equity – Class B. These are likely the general partner investors who carry the most risk and are the last in priority. They have no preferred return and they will only receive their 30% split of the 70/30 distributions if the property cash flows are greater than the projected 7-8% preferred return that the Class A investors are projected to receive.
The dual-tier stack is a little more complicated. Still, it’s becoming more popular because this waterfall structure can provide higher cash flow to class A investors with the tradeoff that Class A investors will not be participating in capital returns upon the sale of the property.
The first priority status again is the Senior Debt and includes any mortgages or loans on the property.
Preferred Equity Status
Next, there’s a Preferred Equity – Class A level. This group receives projected cash flow at a preferred return only with no other projected payouts. The preferred return might be say 9-10%, but they receive no other payouts beyond their return and do not share in the profits when the asset is sold.
This scenario is ideal for an investor who wants a steady higher return and is just looking for consistent distributions. This Class A Preferred Equity status will most likely comes with a higher investment requirement than other tiers and the availability of shares is usually very limited due to its popularity among investors. A common scenario might be that there will be less than 30% of the deals’ shares will be available for a required minimum of a $100,000 capital investment.
Common Equity Status
After the Class A level, you have the Common Equity – Class B investment level, which may include preferred returns, splits beyond the preferred percentage, and capital returns participation. So that may look like this in a scenario – a $50,000 capital investment would earn a projected ~ 7% preferred return with an opportunity to receive a portion of the 70% of the 70/30 split, and a portion of the capital returns at the sale.
Trickling down the waterfall, the last level would be the Common Equity – Class C. Remember, these investors carry the highest risk and the lowest returns because they receive cash flow after other tiers. An example of payout at this level might look like 30% of the 70/30 split and capital returns after the sale in exchange for a $50,000 investment.
As always, the capital stack and the waterfall schedule are presented to all investors and detailed in the PPM (private placement memorandum) and are available to you as a potential investor well before you commit to the deal. Although PPM’s are not a lot of fun to read, it is important that all potential investors fully read and understand how these structures are presented in the offering.
Now that you have a better understanding of these structures and how they affect your returns, you will be better able to find real estate syndication deals that are aligned with your investment goals and will ultimately help you to achieve your goals faster. Knowledge and clarity are power, and continually learning will help you stay on top of your game as a well-versed commercial real estate investor.
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