Insights into the Capital Stack

There's different kinds of equity And you mentioned before we started recording that You know, there's, there's ways to think about it from a risk perspective. There's ways to think about it from a type of capital perspective. There's ways to think about it in terms of who gets paid out first in the event of a waterfall or exit. So Paul, I'll turn it over to you. Help, help us, me, investors listening.

Tell us a little bit about the ways that you can invest the different types of capital and the ways that you guys think about financing some of these deals.

Um, but to try to give the investors a, an understanding of sort of risk and return and features benefits and so as they're reviewing multiple offerings, they can see and understand the difference in, for example, senior debt versus preferred equity versus mezzanine debt versus common equity, uh, and what each offers an investor.

And I can't Um, help, but also maybe put a little bit of insight in there from a sponsor perspective because, um, there are, there are reasons why those different areas in the capital stack are attractive to sponsors or, or not attractive to sponsors. So, yeah, we're gonna, we're gonna attack it from an inverse order. Really starting with the part of the capital stack that has the least risk. Which is senior debt. Um, senior debt is, is debt that is secured by a deed of trust.

Um, and secured by the property itself. It typically carries the lowest return in the capital stack, but also represents the lowest risk. Because as a lender that has a, a lien or deed of trust on the property, if something were to go wrong in the deal, you have the right to, to take. possession of the property in order to to repay the debt, the loan that you've made.

And and typically, for example, in self storage, we're required to put at least somewhere around 30 percent of the cost of a project into it as equity. So you've got a 30 percent buffer. If you're the senior lender, that that project has to be, you know, worth 70 percent of its projected value. It's cost to construct before the senior lenders exposed at all. But they're protected by, like I said, a deed of trust and a lien, a promissory note on the property.

And there are tons of senior debt funds out there today that are offered investors the opportunity to invest with a sponsor who's then going to in turn loan that money, uh, to a developer or someone that's acquiring real estate. And the senior debt typically carries current cash flow.

In other words, you're going to get a quarterly or a monthly dividend that that's reflective of the interest rates that the debt fund is charging And in some cases they're going to provide some liquidity You're going to be able to resell your your interest or your shares in that debt fund to the sponsor and and get you know, get your cash back.

Um, not all funds offer that, but a lot do, but it's a lower return in today's environment, probably somewhere in the 67 percent range in terms of return. Um, but lower risk and in some cases does offer some liquidity, which is not common in real estate. Real estate is generally an illiquid asset, and you know, you really don't get true liquidity until you sell the property.

Um, and, and essentially in commercial real estate it's really no different. Obviously, uh, the risk is a little different and the terms are often quite different. But it's the same thing. It's the senior debt, it's the senior lender that has the first lien on the property. Um, and is in the most protected position of anybody in the capital stack.

So, um, if the property were foreclosed on by the senior lender, um, and the proceeds from the sale only, enough cash to pay back that senior loan, the mezzanine lender would be left holding the back. Um, so it's a little bit riskier. Um, it's, it's quite common in corporate finance, and in fact in corporate finance, mezzanine debt often also includes an equity component, like warrants to purchase shares, or other equity like mechanism that gives the mezz debt a little upside.

That's not really common in the real estate world, and it really is additional leverage over and above. what the senior lender is willing to do, um, and therefore, because it's a little riskier, provides a little bit higher return or interest rate. Um, then the, the mezzanine, I mean then the senior lender, and it's often shorter term. You know, senior debt may be on a 20 year amortization or a 25 year amortization.

Um, in today's world in commercial real estate, shorter am, longer amortizations but shorter terms are not uncommon, a 5 or 7 year term with a 25 year amortization. Mezzanine debt is usually shorter term in nature, probably five to seven years or less. Um, in in most cases, uh, and it does carry, like I said, a little bit higher rate because it's a little higher risk for the lender.

Um, and, and it's not quite as common in small to medium sized commercial transactions, more common and very large. Um, I'm talking, you know, 100 million and up transactions. Um, and it's not an area. They're not as many offerings for investors, particularly high net worth investors in the mezzanine sort of tranche of the trap of the capital stack. Uh, but it is there and it is used in commercial real estate. Um, and it just falls second in line in terms of risk.

Um, it's second in line for a sponsor in terms of cost. It's less expensive than preferred equity or common equity. But more expensive than senior debt. Um, and so it's, it is used, you know, Fairly commonly in commercial real estate, it's something that we typically don't do in any of our funds. Our funds are, typically our capital stack is very simple. It's common equity and senior debt, which is not uncommon in the real estate world.

But, uh, the mezzanine piece is an interesting piece, a little bit of a hybrid, uh, that does provide a little bit of additional return. Uh, and there are mezzanine funds out there for investors who want to invest in that tranche of the capital stack.

Um, the senior lender will require certain conditions be met before the mezzanine lender can be paid. Sometimes it'll allow interest payments, but no principal payments, um, unless certain conditions are met. Um, but it is a second lien on the property that stands behind the senior debt. Um, and there's some interesting opinions on mezzanine debt. If it is used in an attempt to over leverage A property. I think it carries a tremendous amount of risk. Um, leverage is a two edged sword, right?

It, it increases returns on equity, um, but it also can overburden a property and make it very difficult for that property, if something doesn't go just right, to meet its debt service requirements. And when you do that, you expose the other part of the capital stack, which is the equity part of the capital stack. I'll tell you, I cut my teeth in the real estate industry, and particularly in real estate syndication, started in 1981.

And from 1981 to 1986, there were a lot of tax motivated transactions. And they were, they were really designed to create write offs for investors, more so than they were to provide really solid economic returns. Not, not all of them, but a lot of them. And so, in order to boost the tax benefits, um, there was a lot of leverage in those, a lot of those transactions.

And mezzanine debt was probably even more common then, because you had senior lenders that would only go so far, but a sponsor wanted to really lever the deal up. Um, and, and, and create a disproportionate amount of tax benefit relative to the equity in the deal. Um, and about 19, not about, in 1986, the government passed TEFR, the Tax Reform Act, um, that changed a lot of the rules.

And you saw a lot of those over levered deals hit the wall and explode, uh, because they simply couldn't sustain the, the economics of the project with the cost of debt that they were carrying. So, um, I think it's, it's, it can be. Um, I think it's a positive thing and it can be a good place to invest.

Um, but I think it's a place to invest with some caution because if you think you're making an investment that has very limited risk, um, and it's mezzanine debt, that may or may not be the case, if that makes any sense. Next

The second guy to get paid is the Mezzanine Lender. The third person to get paid generally is the Preferred Equity Investor. Um, so it stands in front of the Common Equity in terms of risk exposure and distributions upon a sale. Um, the difference between Preferred Equity and Common Equity is that Preferred Equity typically carries a fixed coupon or return. Um, it, it depends on how the deal is structured, but in some cases, um, some of that is, uh, paid actively.

So, in a, in a preferred equity position, maybe the total coupon is 12%, and 6 percent of that is paid actively, and the other 6 percent is accrued and paid when the property's sold. But in all, you're gonna get a 12 percent annual return on your investment, but it's a fixed interest. It's, it's, it's, it feels in some ways like debt because it has a fixed coupon attached to it. Um, but it functions like equity because, um, you're standing behind the senior lender, uh, and the mezzanine lender.

You do not have a lien on the property. And, and if the, if the waterfall upon a sail doesn't get to you, in theory you can lose all your money. Um, and that's really not. Realistically, not the case with a senior lender. Maybe the case to some degree for a mezzanine lender, but the preferred equity investor is generally more exposed than either of the debt tranches in the capital stack. Um, but they're going to get paid before the common equity does.

Um, and, uh, like I said, usually carries a fixed return. We've even considered adding a PREF equity class in our fund structure. Uh, we may look at it for a future fund. From a sponsor standpoint, senior debt's the least expensive, mezzanine debt's a little bit more expensive, PREF equity, a little bit more expensive yet. Um, but all three are significantly less expensive than common equity, particularly in a project that does well.

Because the difference between preferred equity and common equity is that there generally is no fixed return for common equity. Um, and you're totally exposed in terms of the possibility of losing all of your investment, uh, if the other tranches in the capital stack can't get repaid through the sale of the property. However, in a property that goes well, your upside isn't capped.

Um, you're going to get whatever proportion of that common equity distribution, um, that you're entitled to based on the sharing arrangement and the, the, uh, waterfall within the fund or entity that you invest in, but there is no cap on that. Um, and so ultimately in a project that performs very well from a sponsor's standpoint, that's the most expensive capital of all.

Um, and as I said in in our current fund, and, and right now as planned in our future funds, we really only have two of the four tranches of, of the capital stack, uh, in our capital stack. And that's. Common equity and senior debt, uh, with no MES debt or preferred equity, you know, in between those two. I hope I've done a decent job of sort of explaining the differences in them. Uh, I feel like sometimes I'm maybe not quite getting all the way there.

But, um, there are, as I said, each of them offer an investment opportunity. They have different risk and return profiles. And depending on the vehicle in which you invest in them, uh, they could have different degrees of liquidity. Common equity in real estate is typically not liquid at all. You're, you're going to get your original capital back in whatever return you're entitled to, uh, when the property's sold.

Um, you may get some cash flow distributions along the way, but in terms of redeeming your interest or getting your original principal back, that's really going to require sale of the property. Some of the debt funds do allow for redemption and therefore the ability to get your principal or part of your principal back along the way. But, uh, but the common equity generally doesn't. So

For example, in our transactions, which we are development oriented, which means there really is no operating cash flow for a period of time, um, in a development environment, the pref equity is not probably going to get any current return at all. All of their return is going to come at the end of the project when the project is sold, because there is no cash flow.

You'd essentially be giving people back their own money, right, if you were paying any return at all because it's, it's, You're just paying them back their own money. That doesn't make any sense. I'll give you an example. Um, about six years ago, uh, I developed an 80 million mixed use project just outside Charlotte, North Carolina. And, um, we had a substantial amount of our equity in it, but we also needed, um, some additional equity. And we worked with a group, um, out of Charlotte.

Happened to be Center Lane Capital, great bunch of guys, and they put together an offering, went to their investors and the, the, the, and it was all preferred debt. So they basically invested $7 million in the project. Um, because it was a development project, there was no current return on that $7 million. But when the property was sold, they got back their $7 million plus 14% per annum.

For the entire period, their money had been invested, and once they received that, they've now been paid out, and the next funds that were distributed from that sale were paid to the common equity. I don't know if that helps clarify a

Mezzanine debt is, is a second loan, so again, different risk profile, different interest rate because of the risk. Preferred equity is equity. But it doesn't have a lead on the property, and it usually has a fixed return, um, versus the common equity that, that is the riskiest position, but also has the most upside. Hey, look, here's the reality in investing in anything. Risk and return are inextricably linked. The higher the risk, the higher return you should expect.

The lower the risk, the lower the return you should expect. And risk here is defined by the ability to, to first get your original capital back, and secondly, to get the return that you started out and invested for in the beginning. Um, and senior debt, high probability of getting your principal back, high probability of getting the return you were promised. Mezzanine debt, slightly less probability or, or slightly greater probability.

Lower probability of getting your principal back and of getting your, uh, of getting the return that you were looking for, but, but certainly a significant expectation that both of those things will happen. Preferred equity is a pretty protected position as well.

Um, you're gonna, you know, you're, the, the common equity that invested in the deal can't get a dime of their original principal or return until the preferred equity has gotten all of its principal back and whatever return they agreed to. Um, so again, we kind of went to that bottom up, senior debt to common equity, but that's how they all relate to each other and, uh, um, and, and, and therefore how investors should think about them.

Um, at the end of the day, it's about risk adjusted returns and is the balance between the risk and the return appropriate, um, and not distorted.

That's got all four types Maybe some wisdom or just some kind of decision criteria that helps me understand where do I want to fit in that capital stack. I don't know if you have any that come to mind, but that's kind of where I go with that. And then I also, if you don't mind, just a few more minutes too, is, um, why you guys chose just the senior debt and the common equity.

And if you've looked, you know, you mentioned looking at some of the MES debt or preferred equity, but why you ultimately stuck with those two, maybe, maybe just a few comments on both of those questions.

That would apply to somebody who's approaching or in retirement, where they don't have a lot of time to recover from an investment that goes sideways. Um, and at that stage of life, they're typically looking for current income, right? Because they may be retired and they're living off the investment income they can generate. Um, and so, it's really driven by your investment.

The other thought you triggered when you asked the question is, if you're going to invest in any one of those tranches, but we'll use senior debt for now, what skill set is critical for the sponsor that you're investing in? And the answer to that, particularly for senior and mezzanine debt, is their ability to underwrite risk. So, think about the process that you went through when you bought a house. They wanted your bank records. They wanted your credit card statements.

They wanted, that's called underwriting. They were, they wanted your credit score. They were evaluating your ability to repay that loan. Commercial underwriting is no different. They're looking at the viability of the project. They're looking at the projections for the project. They're looking at market data. They're looking, as a lender, they're looking at the sponsor and his experience and his track record.

Um, and, and, so if you're investing in a debt fund, whether it's mezzanine or senior or some combination of the two, they're basically acting like a bank and making loans. And so you want them to have a You know, wide and deep expertise in the underwriting of those loans and identifying the risk. Um, because you might underwrite the right project, but offer too much debt. Like, the project may be okay, but if it's over levered.

So, not only the ability to evaluate the project, but also to evaluate how much debt. should that project really get. So anyway, I probably went too far there. Um, but that's the other, the other piece of it. But it really is, you know, again, a slide, I went inverse. The, the first thing we talked about, senior debt, has the least risk. Common equity has the most risk.

Um, I would tell you in the corporate finance world, there is a real possibility um, that whatever stock you buy could ultimately be worthless, right? I mean, that, that's a real possibility. A little less true in, in real estate, because it's a tangible asset, um, tends to never go to zero. But, if there's leverage involved, and the leverage is obviously in front of you, it's not impossible in a real estate transaction to wind up with a common equity getting nothing back.

It doesn't happen very often, but it's not impossible.

Um, and the way we leverage our projects and because we're in an arena in self storage and office industrial flex that It has pretty consistent consumer demand, um, you know, the common, when I say it has the highest risk, that doesn't mean it's overly risky, if that makes any sense. But I can tell you this, we've done a hundred, a hundred, over a hundred, um, invest, we've made over a hundred investments, ninety of which have gone full cycle.

There's not one instance in which we haven't at least given our investors every dollar they gave us back. We, we've had a couple of projects that were in the single digit return, so original principal plus a 2, 3, 4, 5, 6 return. Fortunately for us, they're very, um, rare. But we've never not been able to, you know, give our investors their principal back, so.

If you're buying existing properties with established cash flows, that's the least risky play in the real estate world. But within that development world, that vertical development world, which is where we sit, We're developing a product that has historically been more predictable than the other segments.

Self storage in Office Industrial Flex has had just such consistent demand over time that it's a little harder to screw it up than it is developing an office building or shopping center or, you know, other types of multifamily, um, where demand and, um, you know, ebbs and flows dramatically in some markets. So, anyway.

So I hope that listeners are taking notes and re listening to this and thinking through it because it is actually super, super helpful.