As Passive investors in a limited partnership, it is crucial to know who gets the cash flow first, when investing in syndications (an apartment building syndication for example). For that matter, you want to know who is getting paid second, third, and fourth also. There is a pecking order when it comes to getting paid in syndication. Although "preferred return" sounds comparable to elite status when boarding a flight, you may be surprised to find that you fall down the food chain. There are debt obligations and preferred equity holders that have priority over the LP's with the preferred return. The less equity or debt ahead of you equals a lower level of risk. Clarity on this concept is critical because you need to know where you fall in order of priority for returns. I am referring to the capital stack, and it is the order in which funds are paid in a commercial real estate investment. It would seem counterintuitive to say you want to be at the bottom of the capital stack. However, being at the bottom puts you in the first place to receive funds when it comes to the order of the components of the capital stack. You always hear it is best to be at the top of the totem pole. Well, in a capital stack, it is best to be at the bottom because it is more stable with less risk. Think of the game Jenga. Which has more danger of falling and collapsing to the bottom, the pieces at the bottom or the top?
So what makes up the "pieces" of, say, a multifamily property debt/equity structure? In one deal, you can have many different sources making up the capital. You can have senior debt, equity investors, mezzanine debt, common equity holders, preferred equity investors. Let us not forget the deal sponsor (general partner) equity. As a general rule, senior debt comes first, followed by mezzanine debt, preferred equity, common equity, and sponsor equity. Let's take a look at each of these individual components.
Dissecting The components of The Capital Stack
Senior Debt: Senior debt is secured by a mortgage or deed of trust on the property itself. If the borrower fails to pay and defaults on the loan, the lender can take title to the property. This potential default significantly reduces risk because, at worst, the lender owns the property and will look to maximize value by selling the property or selling the non-performing loan.
Mezzanine Debt: Mezzanine debt is less common. If placed in the stack, it bridges the gap between debt and equity financing. It is one of the highest-risk forms of debt - being subordinate to senior debt but senior to pure equity. Put another way; mezzanine debt sits below senior debt in order of payment priority. They can come in the form of second mortgages and bridge loans. Mezzanine debt typically carries preference over preferred equity in cases where the capital stack includes both. For this reason, the mezzanine offers a lower return.
Preferred Equity: Frequently, Limited Partners who hold a "preferred return" or a pref may mistakenly believe they are the pref equity. Even with a preferred return, a limited partner is still common equity. Preferred equity investors are paid before the common equity holders receiving distributions and therefore carry lower risk.
Common Equity: The riskiest position, the highest in the capital stack, also carries a higher return. Equity investments have the most significant risk because every other tranche of capital is repaid before common equity holders. Still, there is no cap on the upside. Conversely, preferred equity is considered less risky than common equity. Hence, preferred equity investors entitled to the upside will be capped.
Single and Dual Tier Capital Stacks
There are two main types of capital stacks - single and dual-tier. Understanding the tier structure in which returns are paid in a real estate syndication is one of the more important things for you to know. Understanding helps you align your investing goals. Your knowledge of the risk and priority at each tier is a vital piece of understanding why and when you'll receive distributions.
Single-Tier Stack
Senior debt is at the top in a typical single-tier stack, carrying the lowest risk and ranking highest in priority.
Next in line is the Common Equity - Class A preferred return below the senior debt. The A-tier takes the preferred position with less risk and lower upside. If your goal is cash flow, you will choose the A tranche as it pays you a guaranteed COC% but caps it there, limiting your upside.
The last level in a single-tier stack is the sponsor Equity - Class B. The general partners carry the most risk and are last on the priority list. They have no preferred return and only receive their 30% promote (from the 70/30 split) if the property cash flows are greater than the preferred return of the Class A investors.
Dual-Tier Stack
The Senior debt is first in line, followed by any subordinate debt, like the mezzanine or bridge debt touched on earlier.
Next, there's a Preferred Equity - Class A level. This group receives projected cash flow at a preferred return only. For example, this might be 9-10%, with no payouts beyond that and no capital return. This is perfect for investors who are only looking for consistent cash flow distributions. One caveat might be that this Class A Preferred Equity status likely comes with a more considerable up-front investment with limited shares available. For example, less than 30% of the deals' shares might be available for a minimum $100,000 capital investment.
After the Class A level, you have the Common Equity - Class B investment level, including preferred returns, splits beyond the preferred percentage, and capital returns participation. If you seek capital appreciation, you will choose the B tranche, as it may sacrifice more consistent passive income during the hold time period but enable you to participate in all the upside. For example, maybe a $50,000 capital investment would earn a projected ~ 8% preferred return, 70% of the 70/30 split beyond the 8% pref (preferred return), and 70% of the profits at the sale.
Trickling down the waterfall (more on this in a moment), the last level would be the Sponsor Equity. These investors carry the highest risk and the lowest returns because they receive cash flow after other tiers. As mentioned, an example of payout at this level might look like 30% Promote (of the 70/30 split) and capital returns after the sale.
The Waterfall
Once we take care of the debt, a waterfall is used to distribute the funds based on met return hurdles (laid out above in the A/B structure). In another example, let us assume that a portion of preferred private equity is positioned behind the debt. The deal structure may say that once a return of 10% is hit, the waterfall now spills down to the next pool or group of investors, the common equity. This 10% preferred return to the preferred equity may limit cash flows to common equity during the life of the hold. Still, the pref equity may be capped at this 10%, not allowing them to participate in the upside, similar to the A shares and B shares tier structure.
A waterfall structure is outlined in each deals' PPM (Private Placement Memorandum). It explains who, how, and when each general or limited partner gets paid during the real estate syndication deal. Keep in mind that any common equity or preferred equity partner is not in a position of debt. Also, cashflow distributions are paid out to partners after expenses, fees, and debt on the property.
Investors Need to Understand the Consequences of The Capital Stack
Individual investors need to do their due diligence on what makes up the capital stack and how it might impact their investment. Do they have the risk tolerance for being placed higher in the capital stack and perhaps more financial upside?
The capital stack affects investors in three main ways:
Cash on cash
IRR
Velocity
Cash on cash returns is the before-tax earnings an investor makes on their invested capital, also referred to as cash flow or distributions. Again if you're in the preferred A-tier, you may have more significant cash on cash returns. Preferred investors have a higher priority, thus get paid first.
The Internal Rate of Return (IRR) is a metric to measure the deal's profitability (cash and equity). It calculates the return while accounting for the time value of money. This concept holds today's money more valuable to you than that returned to you in the future.
Velocity is your ability to invest in more deals at a faster rate. For example, when a deal is refinanced, you may get some capital back if you participate in the B tier or common equity. You can take that returned capital and invest in another project. This way, you're effectively getting returns on two real estate syndication deals when you initially only had the money to invest in one deal. This combination of capital appreciation and multiplication is how one begins to grow serious wealth.
Now that you understand these concepts, you will make better investment decisions to support your personal financial goals and achieve them faster.
Conclusion
The capital stack is just one area for real estate investors to understand within a commercial real estate transaction.
The capital stack and the waterfall schedule are explained in the PPM (private placement memorandum). They are available to you as a potential investor before you commit to the deal. Hopefully, you now understand the nuances of the capital stack. You are better prepared for reading over the PPM and understanding just where you fall in priority for distributions.
Now that you understand these concepts, your confidence in reading any PPM and selecting a real estate syndication deal that aligns with your investing goals should improve. Are you seeking capital appreciation in exchange for some higher risk? Then maybe you are that "Jenga" piece at the very top of the stack. If you focus more on the cash flow from real estate deals and are happy with solid returns and lower risk, then maybe tier A is where you should be.
Do you have questions about the Capital Stack or any other real estate-related topics? If so, we should chat and see what we have for future investment opportunities that would be the right fit.
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