Optimizing The Capital Stack In Today’s Market

Once you’ve found a great real estate investment opportunity, it will be time to raise capital for the transaction. This step typically involves structuring the layers of equity and debt. In simple terms, equity refers to money that you’ll bring to the table and debt includes the different types of financing you’ll secure for the deal. You’ll likely be working with a partner for this step, along with other investors and lenders.

For simplicity purposes, in this article we’ll look at two types of equity: common equity and preferred equity. In a future article, we’ll consider two forms of debt: senior debt and mezzanine debt. Let’s look at the equity portion of the capital stack in the following sections, along with the risks and rewards that each layer brings and how they play out in today’s market.

Common Equity in a Real Estate Investment

In a transaction, the common equity portion reflects basic ownership, and typically includes the individuals in the deal who have “skin in the game.” This could be you, your partner, and other investors on your team. Common equity could come from personal savings or a lump sum of income (such as a bonus or inheritance) that you receive and want to invest.

There is often a general partner, or sponsor, who runs the day-to-day activities of the deal and raises money from limited partners. The sponsor may contribute anywhere from 5% to 50% of the common equity, depending on the size of the transaction. If you’re the general partner and are putting in your own funds, it can resonate well with your investor partners and show that you have confidence in a deal.

Those who contribute common equity carry the highest amount of risk, as they hold the lowest priority in the capital stack. They’ll be paid last, after lenders receive their funds and those with preferred equity have been given their share. On the upside, those who contribute common equity have the greatest potential for reward too. Once a certain threshold is met, they’ll receive a share of the profits called promote, and there generally is no cap on how high of a return they can receive. If the investment yields a significant return, the extra funds will be theirs to keep.

Preferred Equity in a Real Estate Investment

Investors who contribute preferred equity have benefits which go above basic ownership. The rate of return for preferred equity is typically fixed, which makes it have less potential for reward than common equity. However, it also carries less risk, as those who contribute preferred equity will be paid before individuals who put in common equity.

When the general partner seeks preferred equity, one of the first networks to tap is often friends and family. As Jordan Vogel, co-founder of Benchmark Real Estate Group, mentioned on my podcast, “The Insider’s Edge to Real Estate Investing,” when raising capital, he and his partner created a list of everyone they knew that they thought could write a $50,000 check. Some investors gave $25,000 and the higher amounts averaged $100,000.

Before asking for an investment, it’s good practice to begin educating potential investors about the market and your business plan. You’ll want to cultivate the relationship and build an audience; once you have a deal to present, you’ll have established credibility with them. Most of the time when you’re raising capital, you’ll be interacting with accredited investors by using a private placement. Given this, you’ll definitely want to consult an attorney on how to approach them and make sure you’re raising money the correct way without violating any of the rules.

There is typically an order for how preferred equity investors and common equity investors receive their funds and profit share. The sequence is usually that investors get their equity back and then the general partner gets their equity returned. Following this, investors receive their preferred return. Then the sponsor receives their return, and lastly the promote.

Equity in Today’s Real Estate Market

When building a capital stack, bear in mind that in recent times, the lending environment has grown more challenging. In previous years, it might have been possible to have a 65% or 70% loan to value in a deal. (Loan to value refers to the loan amount divided by the total value of the property.) However, those figures may now be in the rearview mirror. As a result, you may be asked to bring more equity to the table than in the past. This can be true even for a cash-flowing asset. Many of the transactions today may require 40%, 45%, or even 50% of equity.

When gathering funds in today’s market, keep in mind that equity is typically more expensive than debt. Even with rising interest rates, the senior debt for a cash-flowing multifamily property might still be below 6%, whereas equity investors are usually looking for more. Depending on the risk profile of the transaction, preferred equity contributors might ask for a single high digit return. They’ll also usually be looking to benefit from the upside potential too. Many equity investors out there are ultimately aiming to solve for mid- to high-teens rates of return, which is not all that different than institutional investors.

Given the need for more equity, along with the additional expense it carries in a transaction, it’s important to raise this portion of the capital stack in the right way. With that in mind, we’ll cover this topic in depth in an upcoming article, which will explain how to build your best investor presentation.

We’ll also discuss the remaining layers of the capital stack—senior debt and mezzanine debt—in a future article. With a solid grasp of these concepts, you’ll be able to properly structure a transaction and move forward with the deal. Even in today’s market, there are plenty of opportunities for those who have the right team in place and the inside track needed to gain a competitive edge.