Understanding the differences between equity and debt investing

[Charles Clinton]

Every homeowner understands the difference between their mortgage and the equity they have in their home but when it comes to commercial real estate transactions, the difference between equity, preferred equity, mezzanine debt and senior debt can confuse even savvy investors. The simplest deals will be just equity and senior debt, while the most complicated may have multiple tranches of mezzanine debt or senior debt that is later syndicated out into multiple notes. For now, let’s focus on the four categories you’re most likely to encountering when investing in real estate through an online investment or crowdfunding platform, going from the least to most risky:

Senior Debt is secured by a mortgage or deed of trust on the property itself so if the borrower fails to pay the the lender can take title to the property. This greatly reduces risk on the principal invested because, at worst, the lender owns the property and will look to maximize value by selling the property or selling the non-performing loan. The "cost" of this lower level of risk is a lower yield on the money invested. To properly understand the risk involved, look at the loan-to-value ("LTV") ratio of the loan - if the loan has a 60% LTV there is a lot more margin for error than an 85% LTV loan. It's a simple analysis, in the worst case scenario as the lender you'd much rather end up owning the property at 60% of its value than 85%.

Mezzanine Debt sits below the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the fixed coupon of the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called an intercreditor agreement, where they spell out how their rights interact (i.e., what happens if a developer stops paying both of them). Mezzanine debt typically has a higher rate of return than senior debt but lower than equity.

Preferred Equity is perhaps the hardest portion of the capital stack to speak about generally because it’s, for better and worse, very flexible. It gets it’s name because preferred equity holders have a preferred right to payments over regular equity holders. In terms of other characteristics, they will range from “hard” preferred equity, which can be very similar to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or kick out the developer if they fail to make payments, soft preferred equity holders typically have more limited rights. As you’d imagine, the rate of return for hard preferred equity is similar (or slightly better) than mezzanine debt, while soft preferred equity returns can be substantially better.

Equity is the riskiest and most profitable portion of a real estate deal. Typically the developer (often called the sponsor) will be required to invest some portion of the equity to have skin in the game. As an investor in equity your risk is the greatest because every other tranche of capital is entitled to get paid before you. However, if the property does well equity investors usually have no cap on their potential returns. In real estate, equity is typically structured so that all investors earn a preferred return until they hit a certain annual return hurdle (i.e., 8%). After that, the developer will earn a disproportionate share of the profits (i.e., 40% of all the remaining profit), while investors receive the rest of what’s left pro rata.

If you’re new to commercial real estate investing, this is a lot to learn but once you get past the jargon it all starts to make sense.