Equity kickers, also called kickers, sweeteners, or wrinkles, incentivize lenders to provide funding at a lower interest rate. In exchange, these financiers receive an equity position in the borrower's company via common stock, warrants, or a share of the revenue. The equity kicker helps close a deal by increasing the return on investment for the lender.
Equity kickers are most often used for higher-risk transactions like a leveraged buyout (LBO), equity recapitalizations, and real estate transactions to compensate the lender for the higher probability of default.
What is an equity kicker in real estate?
Equity kickers are used in real estate to help close riskier financing transactions at a lower interest rate. Lenders will provide the reduced rate in exchange for some form of equity in the deal, such as direct ownership interest in the property, warrants to buy a stake at a set future price, or a share of the total income or gross rental receipts of an investment property above certain levels. In some cases, borrowers offer an equity sweetener to help close a deal, while in others, a lender will demand equity to compensate them for the increased risk.
How do equity kickers in real estate work?
Real estate investments require a significant upfront investment, especially for development and redevelopment projects. Because of that, most investors don't finance these deals with 100% equity. Instead, they often rely on debt financing to cover at least a portion of the acquisition and construction costs.
However, in some cases, there's still a gap in the capital stack between the equity an investor plans to put into a deal and the amount of senior financing they can obtain. That leaves them with two options:
- Bring on other equity partners (including preferred investors).
- Secure subordinated debt like mezzanine financing.
Because options in the middle of the capital stack like a mezzanine loan or preferred stock are riskier than senior debt, they typically carry a higher interest rate. However, a borrower can potentially secure a lower rate by kicking in an equity interest. This sweetener usually comes in one of two forms:
- A guaranteed share of the property's income over a specified level or for a portion of the contract. Lenders use this type of kicker when financing income-producing real estate, though it's illegal in some areas
- A share of any potential increase in the value of a property upon its eventual sale. Lenders will use this equity sweetener on a property that the borrower intends to sell after completing a development or redevelopment project.
What's the difference between equity warrants and equity kickers?
In addition to direct equity in the property, some equity kickers can also come in the form of warrants. These tools give the owner the right, but not the obligation, to purchase shares at a set price in the future. Instead of offering a direct equity kicker in a development project, a developer might provide mezzanine lenders or preferred investors with warrants to buy a share of the project at a fixed price upon completion. If the project performs at or above expectations, these equity kicker recipients can exercise their warrants to buy a stake in the project. They can either hold it (if the developer doesn't liquidate the property upon completion) or sell it back to the developer or another investor at a profit.
What are some examples of equity kickers in real estate?
Equity kickers help real estate investors bridge the gap in financing projects. One common way investors use kickers is in purchasing an investment property they plan to hold. For example, say an investor finds an apartment building selling at an attractive cap rate that they can buy for $1 million. The borrower secures $800,000 in senior debt on the property at a 5% interest rate, meaning they need to have $200,000 of equity to close the deal. However, because the investor only had $150,000 available, they must secure additional funding to bridge the gap. Instead of taking on an equity partner, the investor can obtain $50,000 in mezzanine debt at 7.5% if they sweeten the deal by providing the mezzanine lender with 2.5% of the property's net operating income.
Another common deal sweetener is warrants provided to a preferred equity investor in a development deal. In this example, an investor needs $1 million to develop a condo building. Because of the project's risk, senior lenders are only willing to provide $500,000 in debt at a 10% interest rate. The investor can cover $400,000 of equity, leaving them with a $100,000 gap. They're able to find other investors willing to satisfy the balance with a $100,000 preferred investment at a 14% rate in exchange for warrants to purchase 5% of the property's equity upon completion at a $1.5 million valuation. The condo development proceeds as planned, and the investor can sell the entire project for $2 million. The preferred investor would then exercise their warrants, entitling them to pocket the difference of $25,000 in additional profit.
Equity kickers help sweeten real estate deals
Real estate investors often need to get creative to obtain all the necessary financing for their projects. One tool they use to bridge the gap is an equity kicker, which entices lenders to approve riskier funding in the middle of the capital stack at a lower rate. These kickers can enable those providing this financing with much higher returns in exchange for the additional risk they're taking on to bridge a project's funding gap.