Debt, Equity, and Waterfalls
Debt and equity are the two main types of commercial real estate investments. In this second part of the Commercial Real Estate 101 series, we will discuss the differences of each type of deal and their associated risks and rewards.
When you go on an online real estate crowdfunding platform, you will see many different kinds of offerings. Most all of them essentially fall into two categories. Equity and debt. These investment categories occupy different positions on the capital stack (shown below), and have different risk-return profiles.
Senior debt is in first position to be paid back and is in a relatively safer position than equity. This is analogous to a bank mortgage on a single family home. In the stacked chart above, 75% of the capital stack is composed of senior debt.
Equity is the owner’s stake in the property, much like a homeowner’s equity in their residence. In the above chart, 25% of the capital stack is composed of equity.
Debt investments are structured so that the crowdfund investor serves as the bank and invests in a private loan to the borrower for a set interest rate. The borrower is a real estate developer or a fix and flipper. In return for the use of your money, the borrower agrees to pay a monthly set interest rate along with fees and points, and at the end of the term, pays back the entire loan amount. Some loans are structured as interest payment only and others may be interest plus principal. Most of these loans are short term loans ranging from 6 to 24 months. The interest rate of these loans are higher than a typical owner-occupied mortgage and range from 7-12%. There are several reasons for this.
- Time is of the essence. The borrower needs to act fast to purchase a property and traditional banks may take many months to approve and close a loan.
- The underlying property may be in a state of disrepair such that a traditional bank will not make the loan.
- The borrower does not have W-2 income verification to secure a traditional loan. Developers usually have inconsistent and lumpy income.
- The borrower may not be creditworthy.
- There is just too much headache and hassle to get a traditional loan. Private loans are faster and easier to get.
Here is an example:
A fix and flipper wants to purchase a house for $400,000. It will put in $120,000 or 30% as equity and will borrow the remaining $280,000 or 70% at 10% interest for one year. The loan-to-value ratio (LTV) is 70%. The $280,000 raise is put on a crowdfunding platform with a $1000 to $5,000 minimum investment, depending on the platform. The investor can expect to be paid a monthly 10% annualized interest rate minus any platform fees (typically 0.25% to 1%).
The investor does not share in any profit from the deal, meaning they do not participate in cash flow or appreciation. If the borrower defaults on the deal, the issuer of the debt – the crowdfund platform, has first position lien on the property. They will foreclose on the property, sell it, and be paid back their investment. If the rehab is incomplete, they will have to finish the project before selling the property.
There is a one important detail that some investors may overlook. Investors don’t actually own the mortgage note like they may think. The online crowdfund platform owns the mortgage note. The investor purchases an interest in a mortgage-dependent promissory note (MDPN). This is a note where investors are paid stated interest and principal from the platform provided the borrower makes payments on the underlying borrower loan. What this means is investors make a loan to the platform and the platform makes the loan to the borrower. The platform’s loan to the borrower is secured by the underlying real estate, but the investors’ loan to the platform is not. This is an important distinction. If the borrower pays on time, everything is well- the platform gets paid, and the investor gets paid. However, if the borrower defaults on payments, the investor has no recourse except to hope that the platform gets them their money through some workout loan extension or foreclosure. This detail might be small, but it’s important for investors to know what they are actually buying. The benefit of investing in debt is it is a relatively safer investment in the capital stack. The downside is the return is capped at the set interest rate.
There are risks to investing in debt, just like any investment.
In PeerStreet’s private placement memorandum (PPM), for example, a list of risk factors takes up 18 pages. It lists each and every way an investor can lose their entire investment. Some more important ones include:
- If the borrower does not make a payment, the platform is under no obligation to pay the investor.
- The MDPN is not secured
- In the event of a foreclosure, the platform may not be able to recover any of the unpaid loan balance.
- Loan investment loss rates may be adversely affected by economic downturns, local real estate market conditions, prevailing interest rates, unemployment rate, etc.
- Information supplied by the borrower may be inaccurate or intentionally false.
- Property valuation data may be inaccurate.
- Borrower may not have sufficient experience in construction and operation.
There are many many other risk factors so the investor would be advised to read the PPM in its entirety before investing.
In the event of borrower default, the platform handles the workout process at each stage of the default/foreclosure process. Depending on whether the loan is made in a judicial or non-judicial state, the foreclosure costs are estimated at 3-6% of the loan balance. This is to cover legal and administrative costs and fees related to a foreclosure. Other costs may include past due property taxes, property insurance, property management fees, and disposition costs.
Online platforms also holds loans in a bankruptcy-remote entity that is separate from the primary corporate entity. In the event that the platform goes out of business, a third-party “special member” will step in to serve as a trustee to manage loan investments and ensure that investors continue to receive interest and principal payments. All non-invested investor funds are usually held in a FDIC bank insured up to $250,000.
There are variations of debt investing such as mezzanine debt, preferred equity, rescue capital, and bridge loans, but those are beyond the scope of this post.
PeerStreet is an online platform that offers only debt investments and you can read about my $20,000k PeerStreet experience here.
Equity investments are structured so that the investor is positioned in the equity portion of the capital stack.
In an equity deal, the investor is in second position to the senior debt. In a specific deal, the equity position is riskier than its respective debt position. The upside is the investor is entitled to positive cash flow and appreciation at sale. The downside is if a property loses value, the equity investor is unprotected and is the first to lose all or part of their investment.
Let’s look at how a profit structure would work on an equity investment.
When an investor invests as a limited partner (LP) in the equity stack, they will receive a percentage of all profits, including cash flow from rental/ lease income and appreciation during time of sale or refinance. The profit distribution structure is called a ‘waterfall’. A typical waterfall profit structure may involve an annual preferred return to the LP, then one or more hurdles (waterfall) for profit distribution.
A typical LP preferred return is a 6-10% annual cumulative return. This means the LP investor is paid a preferred return first before the sponsor sees any profit.
After the preferred return, there is a waterfall split which can vary, depending on the sponsor.
For example, if there is a 8% pref and a 70/30 split waterfall,
The order of profit distribution would be as follows:
- Repayment of senior debt,
- 8% annualized cumulative preferred return to the LP investor pari parsu (Latin for equal footing), then
- Return of LP capital contribution, (the original investment amount), then
- 70% to LP and 30% to GP (general partner)
Waterfall structure can vary greatly and there may be additional hurdles in place.
For example, after return of LP capital contribution,
70% to LP and 30% to GP up to 15% return, then
50% to LP and 50% to GP on any profits greater than 15% IRR.
Here is an example:
A sponsor would like to purchase a $10 million office building and spend an additional $1 million to improve it. It needs $3 million for the equity down payment and will obtain a $8 million loan from a bank. The sponsor needs to fill that $3 million portion of the equity stack. A portion of it (say $500k) will be filled by the sponsor as “skin in the game”. The other $2.5 million will be put up online via crowdfunding or offline through traditional syndication fundraising. The waterfall structure is 10% pref with 70/30 split and a 5 year hold period. The sponsor’s $500k will be treated equally pari parsu with the LP equity contribution.
The LP will earn 10% each year from the rental income. If there is not enough cashflow to pay the 10% pref, the remaining that is owed will carry over. During time of sale in year 5, the profit is distributed such that after the senior debt is paid back, the remaining profit gets paid out according to the waterfall.
The LP investor will receive 10% annual cumulative pref, (any deficiencies will be caught up) then,
The LP investor’s original investment will be returned,
Any remaining profit is distributed 70% to LP and 30% to GP.
There is no shortage of risk when investing in an equity deal. In a typical PPM, there may be 20-30 pages devoted to risk alone. Some important ones include:
- Sponsor risk
- CAP rate risk
- Debt maturity risk
- Tenant risk
- Physical property risk
- Market risk
- Construction / rehab risk
- Environmental risk
So when doing due diligence on an investment, it is important to find out how the sponsor will mitigate these risks. Obviously risk cannot be entirely eliminated so you need to be comfortable with your risk tolerance and invest accordingly.
When investing in an equity deal, it is important to be aware of what you are investing in, and how you will be investing. Know whether the investment is direct-to-sponsor or through an intermediary investment.
When you invest direct-to-sponsor, you own shares of the actual investment LLC. So if a sponsor’s apartment building is owned under an LLC, you own shares of that LLC. RealCrowd and Crowdstreet are examples of online platforms that operate in this fashion. All cash flow and distributions come directly from the sponsor. All reporting and communication comes directly from the sponsor.
The other way to invest is through an intermediary LLC. For example, if you invest in an equity offering on RealtyShares, you own shares of a RealtyShares LLC. The RealtyShares LLC then invests in the sponsor’s apartment building LLC as a limited partner. All cash flow and distributions come from the platform, not the sponsor. Also all reporting and communication comes from the platform, not the sponsor. As an intermediary, RealtyShares takes a fee. RealtyShares and RealtyMogul operate under this model.
Some other platforms and off-line deal aggregators may even take a separate promote after the sponsor promote. So there may be two different waterfalls (double promote) before profits flow to the individual investor.
My Personal Investment Strategy:
As I’ve hinted in a previous post, I am currently in a wealth building stage of my life, which means I’m trying to grow my net worth instead of living off my investments. So I invest in equity deals which have a higher IRR as opposed to debt deals which have lower fixed IRR. But as shown above, equity deals are generally riskier because of their position in the capital stack. Again I want to emphasize that this type of investment is not for everyone. If you want to invest in this asset class, you must educate yourself and do your own due diligence on the sponsor and the deal. Commercial real estate operates in cycles, just like any other investment. We are in the later stages of the cycle so it behooves the investor to practice even more caution when investing. With the rise of online crowdfunding, all sorts of companies, big and small, and of varying quality and experience, are posting deals and I fear that we may be in a developing bubble of sorts. And because the investor audience is much wider and greater, there is more ‘dumb’ money filling these borderline deals.
Personally, I much prefer direct-to-sponsor investments. The only exception is if an intermediary can offer access to a fantastic deal which I cannot access myself directly. An instance of this is if a top-notch sponsor does not accept individual investors or if the minimum investment amount is very high. I prefer to interact directly with the sponsor; if I have a question or concern, I can have it addressed ‘straight from the horse’s mouth’ so to speak. Going direct also bypasses a separate layer of fees and possible double promote. The drawback is when a deal goes south, there is no intermediary to go to bat for me to defend my interests.
In summary, it is important to understand the types of deals offered in commercial real estate investing. In this article, we introduced the basic differences between debt and equity and some of their respective deal structures. All of these investments are inherently risky so please educate yourself and do your own due diligence. The purpose of my blog is to help others learn about this investing space and learn from my experiences, especially my mistakes. I have much to learn myself but like any valuable skill, the more you practice, the better you get.
Thanks for reading,
Invest In Life.