A few things to notice. First, recall that I said the different types of financing are stacked in order from least senior on the top to most senior on the bottom. In this simplified example, your mortgage lender is the "senior" financing -- meaning that if you can't make your mortgage payments, the lender gets to foreclose and recoup their investment before you're entitled to any money.
On the other hand, the top of the stack typically has the most room for profit. In this example, let's say that you sell the property for $500,000 a few years later. The profit is yours -- the lender only gets paid back what you owe on the loan.
Commercial real estate capital stacks
Not surprisingly, when you get into multimillion-dollar commercial real estate deals, the capital stack can be significantly more complex. While the actual terminology can vary (especially when it comes to types of debt), there are generally four types of financing that can appear in a commercial real estate capital stack:
Common equity - As mentioned, equity investments in commercial real estate are at the top of the capital stack. Common equity investors have the lowest priority when it comes to a claim on a project's assets, and distributions to common equity holders can only be paid after all other promised distributions have been paid.
Preferred equity - Preferred equity in commercial real estate investing can either mean a type of subordinate debt or it can mean a type of equity that has a superior claim to the project's cash flow than common equity. For example, in some crowdfunding deals, the sponsor's contribution might be considered common equity and the investments from people like you might be considered preferred equity, or vice versa.
Mezzanine debt - This is also known as subordinate debt and refers to any debt financing a commercial real estate investment has received that doesn't have the highest claim to the project's cash flows and assets. Think of this as similar to when you have a mortgage and then take out a home equity line of credit, or HELOC. In the event that you default, your mortgage holder gets paid first, and only then can the bank that provided the HELOC recoup its money.
Senior debt - This is the bottom of the capital stack and refers to a project's most senior lenders. Typically, this refers to a commercial mortgage that a project's sponsor has obtained from a bank. Senior debt typically gets the lowest return but is also taking on the least amount of risk.
Advantages of real estate equity investments
When you invest in a commercial real estate deal through a crowdfunding platform, or through a private investment partnership, there are some advantages over debt investments:
- Return potential - This is the number one reason to choose an equity investment over debt. If you invest in an equity stake in a commercial real estate deal, your return potential is unlimited. Let's say that a deal sponsor borrows $75 million and crowdfunds $25 million in equity to complete the $100 million development of an apartment complex. If the apartment complex sells for $150 million after it's built, equity investors will have tripled their money, less fees paid to the sponsor. Debt investors will only receive repayment of the amount borrowed with interest.
- Tax advantages - Many real estate investors are familiar with tax benefits such as depreciation, but many don't realize that by participating in a commercial real estate private equity investment, you can take advantage of these as well.
Disadvantages of real estate equity investments
On the other hand, there are some big potential drawbacks to consider when deciding to make an equity investment in a real estate opportunity:
- Loss potential - While the unlimited return potential can be very attractive, it's also important to keep in mind that equity investors can take losses as well. Let's use the same example of a developer who borrows $75 million and crowdfunds $25 million in equity to build an apartment complex. If the economy crashes and the property sells for just $90 million, equity investors take the loss while debt investors will get repaid in full.
- Other capital is superior - If the worst happens and the real estate investment really goes sour, equity investors can lose all of their money. If the developer cannot make their debt payments and the lenders foreclose, any recovered money is paid starting at the bottom of the capital stack.
- Fees - The fees associated with a real estate equity investment can eat up a lot of your returns. Now, developers and other experienced professionals should absolutely get paid for their work, but it's important to be aware that in a profitable equity investment, the cut of the profits that goes to the deal's sponsor can be huge.
The Millionacres bottom line
Being a real estate equity investor can be a great way to build wealth over time, but it's very important to understand the risks and where your investment falls in the capital structure of a real estate deal before you get started.