Building a Better Capital Stack

The world of real estate financing, in its more complex forms, can seem opaque and typically plays out far behind the scenes of a commercial-property transaction, either in the secondary market or already in motion as part of a project’s original capital structure. Either way, as a commercial mortgage broker charged with assisting buyers or sellers, it pays to gain some insight into trends and investment vehicles in the high-finance arena, given they can affect a particular property’s future financing prospects, marketability and bottom line.

It has been nearly 25 years since the emergence of the modern real estate finance market, and while the industry has evolved into an accepted global-  asset class, its evolution is still in its adolescence. When compared to the sophistication of the broader stock and bond market, the real estate finance market has many advancements to make in order to meet the varying risk-return requirements of global- investment participants.

Prior to the savings-and-loan crisis of the 1980s, the structure for financing a real estate transaction was relatively simple. A bank or insurance company would provide an on-book or balance-sheet loan for the senior debt and the real estate sponsor would provide any remaining equity required, either through a personal balance sheet or syndicated among extended friends and family. Put simply, the capital structure was very “chunky.” That is, there were limited risk-return profiles for investors to choose from to accurately match risk appetite. Relative to senior debt, only a single rate of return was offered to potential investors, regardless of the risk the investor was willing to take on.

On the equity side, there was simply one large return everybody was shooting to attain. Of course, sponsors would have an entirely different internal rate-of- return profile, given their sweat equity and their use of other peoples’ money. But limited-partner (LP) equity investors generally had one risk-return profile available, which was normally equal in weight to that of the general partner — who often had little or no money invested. In short, investors had limited options, on the debt and the equity side, to match the return requirements to a desired level of risk.

Distributing risk

In the early 1990s, the commercial mortgage-backed securities (CMBS) market and equity-opportunity funds became more significant sources of financing. Products of the larger and more sophisticated stock and bond markets, these securities and funds carved up tranches of risk and were embraced by the real   estate finance industry. Should a pension fund require a high confidence of capital preservation, it could  invest in a more protected “super-senior” tranche of the senior loan. Investors willing to take on more risk in exchange for a higher yield could choose a more exposed “BB-rated” tranche of the senior debt. This segmentation of risk-return opened the door for investment participants of all types to customize capital allocations based on investment needs. On the equity side, although the risk-return profile remained chunky, there was marked improvement over the traditional friends-and-family model. Saddled alongside managers of opportunity funds who presumably have a strong track record of real estate   investment experience, investors not only gained an increased level of scrutiny over the general partner, but also had more precise measures of whether to remove the general partner in the case of poor performance or misrepresentation. Additionally, equity investors could identify fund strategies that fit the desired risk appetite of any particular return requirement.

Despite the economic crisis, and Great Recession that was influenced by the evolution of the real estate-finance industry, the changes in real estate finance have been positive for the global-investment community, which can now adequately match investments with stated risk-return objectives. Today, although the debt component of the capital stack (or structure) can be segmented into multiple levels of risk, the matching of risk-return profiles on the equity side still remains less defined.

Under the traditional equity structure, limited- partner investors rise and fall in direct alignment with the real estate sponsor — the general partner responsible for organizing and managing a project. This  relatively volatile position may be tolerable for the sponsors who drive the operational ship and who stand to earn enormous returns from their skills, but not always for the third-party investor who may be willing to accept lower returns to assure capital preservation. If our sophistication allows us to segment risk-return tranches for debt instruments dominating the top 75 percent of the capital stack, then why can’t risk be segmented and priced on the equity side throughout the higher tranches of the capital stack? Well it can, it should be, and it is currently happening within the broad real estate finance industry.

Envying thy neighbor

In the current environment of perpetually low interest rates marked by an increasing concern over artificial asset appreciation, debt and equity investors are looking across the traditional demarcation line at each other’s level of risk and return.

Senior-debt investors are extending further up the capital stack in search of higher yields and more   equity-like returns. Equity investors, on the other hand, are finding solace from the protective position of being further down the capital stack and in a position to take control of a property in the event of sponsor mismanagement. Thus, we are experiencing a blurring of the capital lines, where debt providers are often offering financing that extends into mezzanine and preferred equity strips.

Meanwhile, equity investors are increasingly providing entire loans, allowing them to distribute one class of relatively low-return securities to investors looking for lower risk, while retaining another class that pays a higher return. This evolution is favorable to the maturation of the real estate finance market and subsequent global demand for allocation into real estate as an asset class, but it leaves a murky and vulnerable environment for the real estate sponsor.

Over the years, sponsors and real estate professionals alike have developed their own expectations of how capital should be priced. Although the following definitions can get very granular in nature, given a multitude of factors, we are accustomed to thinking of the following:

■ Senior debt — priced at a return in the mid-single digits (certainly lower single digits in recent years);

■ Mezzanine capital — with low double-digit pricing expectations; and

■ Joint-venture equity — with high teens to 20-plus percent returns for investors sitting in a first loss position.

■ But how does a sponsor make sense of senior-debt pricing that accounts for as much as 88 percent of the capital stack, as is the case with some high- leverage structures? Or, more confusing for a sponsor, what if rather than a joint- venture equity structure, the capital provider is willing to forego some profit potential in exchange for seniority of cash flow distribution and a minority back-end profit participation?

At what point along the capital stack is profit participation earned or not earned? How large should the profit participation be? These are real-time questions that are being astutely examined by real estate investors and capital providers, yet are largely overlooked and misunderstood by real estate sponsors.

Long-term changes

In a world of limited waypoints, the questions surrounding deal structures cannot only become complex, but they also can have a material economic impact on a sponsor’s financial gains.

Minor changes to the structure of a deal can equate to hundreds of thousands of dollars in profit potential, or, lost profit potential. Although there are certainly pitfalls to a sponsor’s interest being subordinate to limited-partner equity, if structured correctly, the sponsor can mitigate downside risk while generating significant upside returns not achievable under a traditional joint-venture structure.

Furthermore, a mezzanine or  preferred-equity structure enables sponsors to minimize the inevitable sell-or-hold conflict that is present under a joint-venture partnership, and provides sponsors with a clearer path toward holding long-term if that is their ultimate investment objective. Because these structural changes may be a more permanent shift within the real estate finance industry, it is wise that real estate sponsors become well-versed in structured finance and the blurring lines of the capital stack. 

David Kidder is president and managing director of Landmark Capital Advisors. He has more than 15 years of commercial real estate experience across all major asset classes, with an emphasis on structuring equity and debt for middlemarket real estate operators. Reach him at