Equity Real Estate Investing: What, Why, & How

Photo by Mihály Köles

This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.

Real estate equity investing generally entails the highest attendant risk and highest potential return of any position in the real estate capital stack. As we will see, there are numerous different legal and payment structures within equity real estate investments that can impact the return potential and risk for any given investor. Further, the investment strategy, property class, and market all significantly impact the risk/return profile of any real estate equity investment.

This article takes a look at different ways real estate equity investments are structured, and some key considerations for individual real estate investors.

Real Estate Equity Investments — The Basics

Real estate developers and investors typically refer to the total financing of a real estate project as the “capital stack”. Note that this financing, or capitalization, may go beyond the purchase of the real estate alone. Beyond acquisition of a property, capital raised for a given investment may include ongoing value-add construction, marketing expenses, and other lease-up costs. Common equity positions are usually longer term in nature: debt, mezzanine debt, or preferred equity positions are more easily replaced or refinanced out of an investment.

In the real estate capital stack metaphor, the total financing of the project is a building, and the equity position is the top floor (or floors, depending on the size of our building metaphor) . Below the top floor sit the lower-upside, lower-risk portions of the total capitalization, including senior debt (which we may consider the foundation of the building), subordinate debt (including the aptly-named mezzanine debt piece), and preferred equity. The lower the position in the capital stack, the more protections investors typically have. Senior debt is so called because it is “senior” to all other positions in the capital stack, i.e. senior debt holders are entitled to be repaid before any other investor in a given real estate investment. Subordinate debt and preferred equity investors hold payment priority over at least one other position in the capital stack, and some recourse in the event that the sponsor (i.e. borrower) defaults. Equity investors typically have no recourse, and are the last to be repaid. In exchange for assuming this risk, equity investors enjoy higher potential upside.

Equity investors in a real estate investment are typically thought of as a partnership, with the sponsor acting as GP (“General Partner”) and passive investors — e.g. individuals investing through EquityMultiple — as LP (“limited partner”).

Distribution Waterfalls and Promotes in Equity Investments

Once debt and preferred equity positions are paid, the particular payment arrangement within the equity structure kicks in. This “distribution waterfall” dictates the order and proportions of repayment of principal and profits among GP and LP investors. This arrangement is determined contractually and is key for any passive investor to understand as they are evaluating a potential investment.

In a common arrangement of profit distribution, a Sponsor (the GP investor) will contribute her own equity to the financing of the project, into the same property-owning entity as the LP investors. The Sponsor will earn the same share of profits up until a certain threshold — “ pari passu “ with LP investors — until a certain threshold return has been met for all equity investors. In our example below, ‘all members’ are defined as the Sponsor’s GP position and all LP investors.

Once this return threshold has been met — and all principal has been returned to equity investors, pro rata — the “sponsor promote” kicks in, and the sponsor earns an outsized share of profits thereafter. To complicate matters, there may be multiple “tiers” of sponsor promote within a distribution waterfall: successive return thresholds after which a different profit split kicks in.

To drive this home, let’s consider an example distribution waterfall from an actual EquityMultiple investment, which can be found prominently in that investment’s Subscription Agreement:

1. First, 100% pro rata to all members until all members have received their respective accrued and unpaid 8% return on capital (the ‘preferred return’);
2. Second, 100% pro rata to all members (equity investors) until all capital contributions (principal) have been returned;
3. Third, 70% pro rata to members and 30% to the Sponsor until all members have received a 20% IRR (the ‘first tier’ of the distribution waterfall) and;
4. Thereafter, 60% to members and 40% to the Sponsor (the ‘second tier’ of the distribution waterfall).

Keep in mind a couple of things with respect to EquityMultiple investments where promotes and distribution waterfalls come into play: a) all target returns are presented net of EquityMultiple fees and b) if you have questions about any particular distribution waterfall, you are welcome to schedule a call with EquityMultiple’s Investor Relations team for clarification.

Why Sponsor Promotes Exist

At first glance, it may appear as though such a structure unfairly compensates a sponsor in the event of a successful investment. However, consider that passive ( LP) investors rely on the sponsor to execute on many fronts, including:

• Sourcing and underwriting assets
• Leveraging local knowledge and a boots-on-the-ground presence to unlock hidden value and enter investments at a favorable going-in basis, often acquiring property at below-market value
• Assuming debt liability
• Formulating and executing on a strong business plan
• Manage tenants — including lease-up, turnover, and lease renewal
• Securing ongoing financing (where necessary) and negotiating favorable sale of assets so as to maximize returns

The sponsor promote structure helps to ensure that sponsors are incentivized to achieve the highest level of return possible, and to compensate for the effort and risk this entails. EquityMultiple aims to negotiate favorable distribution waterfalls on behalf of our investors, but such that sponsors remain incentivized to strive for each incremental dollar of return.

Cash Flow, Project Plans, and Varying Risk/Return Profiles

While equity real estate investments entail a higher degree of risk and potential reward than other positions in the CRE capital stack, equity investments vary substantially in their term, target cash flow profile, risk factors, and exit strategy.

Here are some factors that may reduce the potential risk and dampen potential return of an equity real estate investment:

• Strong, established market: a strong local economy and diverse demand drivers may reduce the attendant risk of any CRE investment within the market, while (partially in response) enhanced competition from other investors may compress cap rates and dampen return potential.
• Stable cash flow: strong in-place cash flow from rent rolls may help to mitigate liquidity risk.
• Limited development scope: less complex and extensive capital improvements means less potential for significant delays or vacancies.

And some factors that may increase the potential return and attendant risk of an equity real estate investment:

• Less-established, burgeoning markets: a market on the rise, with a less established but growing set of demand drivers, typically offers higher going-in cap rates and greater potential for significant appreciation. However, a less diverse, robust set of demand drivers means the market may be harder hit by an economic downturn, increasing potential risk.
• Ground-up development: projects that entail wholly new construction carry more complexity and, generally, offer no cash flow within the term of the investment. These factors amount to a higher degree of risk. However, successful ground-up investments can tap into growth in a market at greater magnitude, and the potential for outsized returns.

While these factors should be considered for investments all across the capital stack, they can have the greatest impact for equity investors who are afforded fewer protections but are entitled to a greater share of the potential upside.

The Big Picture: When to Invest in Equity

As discussed above, the risk/return profile of any equity investment can vary substantially based on other attributes of the investment.

That said, an equity real estate investment may be worth considering if

• You are comfortable with lack of liquidity: your investing goals do not preclude a term of 3+ years (with no contractual entitlement to interim cash flow).
• You have sufficient time to understanding the investment: including all attendant risk factors, and nuances like the specific distribution waterfall of your equity position (as explained above).
• You are long on debt, preferred equity, or non-real-estate fixed-rate vehicles and would like to pursue potential for greater long-term appreciation in your portfolio.

We encourage investors to consider a diversified approach, which includes diversifying across the capital stack. To that end, we want to make sure that the increased nuance of equity investments does not stand as a barrier. Please feel free to schedule a call with our Investor Relations team at any time to discuss further.

Originally published at https://www.equitymultiple.com on July 12, 2019.