What is Capital Structure? Why does it matter?

[Joe Latson]

Hey BP! 

Hope this is helpful for some and happy to dive in more re: the right capital structure for different types of business plans and investors. 

Thank you!

What is Capital Structure?

The way an investment or entity is owned and funded is referred to as its capital structure, or “cap stack” for short. One might ask, “how is this investment capitalized?”.

Broadly speaking, the capital stack consists of two components – debt and equity. Debt is effectively a loan to the investment entity, which most commonly comes from a bank or specialty-lender, but also includes other types of financing like a HELOC or even a credit card. Equity represents ownership in the investment. As such, the equity investors retain “control” of the investment and make major decisions, so long as they remain in compliance with the loan documents.

Investors use debt (sometimes called ‘financing’ or ‘credit’) because it can lead to higher investment returns on their equity and helps stretch their investable dollars further. The amount of debt incorporated into a capital stack is commonly referred to as leverage.

Debt investors benefit from a repayment priority and typically have the ability to foreclose on the collateral if the borrower defaults, therefore it is not as risky an investment as the investment of the equity investors. For that reason, equity investors demand higher returns than debt investors.

All Equity vs. Levered

Let’s say you have $60K of cash to invest in a property.

One option would be to acquire a $60K property. However there are a handful of reasons why that might not be the best option. In that scenario the capital stack would be 100% equity.

Another option is to finance a portion of the investment with debt. With moderate leverage incorporated into the capital stack, say 75%, you can afford a $240K property. Here the capital stack is 25% equity and 75% debt. You would still own 100% of the asset while only investing 25% of the required cash.

Takeaway

Like anything, it gets more complicated from here – there are many types of debt and many types of equity that are useful to understand after you grasp the basics.

The correct takeaway here is that leverage can be a powerful tool.

• It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.
• It allows investors to take on more or larger deals than they would otherwise be able to if limited to their readily available cash.

However, if not used responsibly, or if luck is not in your favor and the market suddenly turns against you, leverage can quickly erode returns and even worse, result in a complete loss of investment.

[Joe Latson]

@Cameron Tope that is a great question! I hope that this answer is helpful, it borders a ramble as there are a lot of situational and strategic drivers that could alter course. 

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As part of determining the optimal capital structure for a particular investment, investors should compare both the unlevered and levered investment returns. This illustrates the benefits of using leverage, which need to be weighed against associated risks.

Typically, if you are in growth mode I would recommend up to 75% LTV so long as you have positive leverage. Positive leverage is when your cost of capital is less than the returns generated from the cashflow of the property.

For example: Interest rate for long-term rental property = 4.5% and your unlevered yield (NOI / Cost Basis) is 5.5%, you have positive leverage.

By utilizing more leverage while you are growing, you can invest your equity across more properties in a shorter period of time. 

As your assets appreciate, your LTV will decrease as a result of the appreciation.

For example: Total cost basis at acquisition = $400k and you get a loan for $300k. This = 75% LTV. Two years later, the property appraises for $450k. Your $300k loan is now 67% LTV.

At this time, you may also decide to refinance out of your initial loan. The reasons to do this would be to either "cash out" or because interest rates have moved in a favorable direction. To cash out means to pull equity out of the deal by refinancing. 

For example: Total cost basis at acquisition = $400k and you get a loan for $300k. This = 75% LTV. Two years later, the property appraises for $450k. You refinance at 75% LTV. The new loan amount is $337.5k. You just cashed out $37.5K.

People do this because the IRS doesn't view the money you take from a cash-out refinance as income – instead, it's considered an additional loan. You don't need to include the cash from your refinance as income when you file your taxes.

You will want to make sure to account for any prepayment penalties at that time, too. Depending on the penalty, if at all, will impact the economics of your refinance. Most lenders will have a step down in prepay penalties over the life of the loan. Common to see 5/4/3/2/1/par or 3/2/1/par, etc. 

Re: Preservation/Protection mode. My personal opinion is that the value of leverage is really dependent on the state of the capital markets... i.e. where are interest rates and is debt working for me or against me? At 75% LTV, the chances of your property decreasing in value 25% or more is pretty low. However, it's not impossible.

I used to represent some large institutional investors in the commercial real estate world. Generally, those investors did not go beyond 60% LTV. The reason being that they weren't seeking the highest rate yields and the cost of capital correlates to the amount of leverage on your asset. Lower leverage = less risk = lower cost of capital.

So, if you are in a stage where you have hit your growth goal and just want to kick back (no such thing as an owner IMO, LOL) and cash flow, it could totally make sense to start refinancing out of your acquisition loans (remaining principal, no or very little cash out) and benefit from the increased cash flow as a result of a lower interest rate loan at a lower LTV than when you purchased the property.

From there, as you keep buying, you might have the equity to start only using debt up to 50% - 60% LTV and the amount of cash you generate suffices your goals and needs!