How Does the Capital Structure Work as a Passive InvestorNov 27, 2023
The capital structure is the combination of debt and equity required when funding a real estate deal. It refers to the layers of capital that go into purchasing an investment property. They dictate how operators will structure the capital needed and evaluate the risk and returns for the investors. It outlines who will receive income and profits generated and in what order and vary depending on the deal’s risk profile, return expectations, and business plan.
The capital structure has two main categories: equity and debt. Debt will consist of funds from a lender that will need to be paid back with interest expense and be at the bottom of the stack. Equity consists of the capital needed from the operator to fund the remainder of the deal.
A passive investor/limited partner in multifamily syndication will be investing their capital into the equity bucket either as common equity or preferred equity shareholder of the project. They sit at the top of the capital structure and receive the highest rate of return for their risk. Common equity is where passive investors have the most opportunity to gain without a cap on their returns through monthly or quarterly distributions of cash flows. Investors are typically paid in the form of a preferred return on their investment and receive a large equity gain through a refinance or sale/disposition of the property. It is one of the most important aspects of the capital structure as operators are raising funds from multiple private investors who get to benefit and share the returns.
Preferred equity is used when additional funds are needed beyond what a senior debt (bank) can provide. Rather than borrowing more funds from a few investors, operators offer preferred equity positions. It is given priority distributions that have a fixed rate of return and larger equity in the deal that entitles them to a portion of the upside of the property when sold at a profit.
Senior debt is at the bottom of the capital stack and holds the strongest priority as the lenders will need to be the ones paid back first. It makes up for the largest portion of the financing (typically 65%-80% of the purchase price) and is first in line to receive debt service payments. It’s considered the least risky and provides the lowest return. If the operator fails to make the mortgage payments, the lender can foreclose on the property to recover the amount owed. Financing the total project cost can vary depending on the risk profile, the borrower, and other factors.
To conclude, the capital structure outlines the financial resources needed to finance a property. It allows the investor to evaluate the risk profile, the hierarchy of power, and where they land on the capital structure. It is crucial to be informed about the positions in the capital structure before choosing to invest.
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