The capital stack refers to the order in which distributions are paid in real estate syndication investments. Understanding this concept is crucial as it helps investors prioritize returns. Understanding the waterfall effect helps select deals with favorable capital stacks for investors’ goals. Knowing the risk and priority at each tier is essential for understanding why and when distributions will occur. This article explains the capital stack, its importance, and its impact on investors.
The Waterfall
The capital stack in real estate syndication deals is a waterfall structure, where debt and equity partners are categorized into groups with the lowest returns and highest risk at the top. Cashflow is distributed like a waterfall, starting at the top and trickling down to those with higher returns and lower risk. This structure is outlined in the Private Placement Memorandum (PPM) at the beginning of a deal, outlining who, how, and when each partner is paid. Some classes receive only cashflow, while others participate in cashflow distributions and capital returns profits. Understanding the waterfall structure is crucial for financial goals.
Are you solely focused on creating passive income in the form of monthly or quarterly cashflow?
Are you mostly interested in appreciation on the property and “winning big” at the sale of the property?
Are you desiring a mix of both – a little support in the cashflow department plus some longer-term gains?
As we explore the types of waterfall structures and capital stack styles, keep in mind that any common equity or preferred equity partner is not in a position of debt. Also, cashflow distributions are always paid out to partners after expenses, fees, and debt on the property.
The Impact
The capital stack affects investors in three main ways:
Cash on cash
IRR
Velocity
Cash on cash returns refer to the before-tax earnings an investor makes on their invested capital, with preferred tier investors potentially experiencing more significant returns. Internal Rate of Return (IRR) measures the deal’s profitability, accounting for the time value of money. Velocity refers to the ability to invest in more deals at a faster rate, such as when a deal gets refinanced and capital is returned. This can be used to invest in another project, effectively achieving returns on two real estate syndication deals. Understanding these concepts and their impact on each position in the capital stack can help make better investment decisions to support personal financial goals and achieve them faster. By understanding these concepts, investors can make better investment decisions to achieve their financial goals.
The Capital Stack
Real estate syndication investments involve a capital stack, where debt and equity partners are ranked based on risk and priority. Senior debt, including mortgages and loans, is the highest priority, with a meager return rate. Second-level loans, such as second mortgages and bridge loans, are also debt positions with lower risk than limited and general partner investors. Preferred equity (limited) partners prioritize after debt payments but before general partners. After the property mortgage, expenses, and fees are paid, preferred investors have “dibs” on distributable cashflow. This tier may require higher investment and limited positions, but often has higher projected cashflow than other investors. Following the Preferred Equity Partners are the Common Equity (general) partners. This tier comes with the highest risk and the lowest priority. These investors participate in capital returns and cashflow distributions but fall after the preferred level, typically with a split of earnings up to a certain percentage of cashflow.
There are two main types of capital stacks: single and dual-tier. The dual-stack is more complicated than the single-stack. Understanding the capital stack is crucial for investors to avoid confusion and ensure a smooth investment process.
Single-Tier Stack
In a single-tier stack, Senior Debt is the top level, with the lowest risk and highest priority. This is often seen in mortgages with a 70% loan-to-value ratio. Common Equity – Class A is below senior debt, with a slightly higher risk and less priority. This level is likely a limited partnership level, earning a 7-8% preferred return with a 70/30 split. These partners participate in capital returns and receive a portion of the profit after the sale. Common Equity – Class B is the last level, with general investors carrying the most risk and no preferred return. They only receive a 30% split of the 70/30 distributions if property cashflows exceed the 7-8% preferred.
Dual-Tier Stack
The dual-tier stack is a popular waterfall structure that offers higher cashflow to Class A investors with the tradeoff that Class A does not participate in capital returns. The stack starts with Senior Debt, which includes mortgages or loans on the property. The Preferred Equity – Class A level provides projected cashflow at a preferred return, with no payouts beyond that and no capital return. This level is ideal for investors seeking consistent cashflow distributions but may require a substantial up-front investment. The Common Equity – Class B investment level includes preferred returns, splits beyond the preferred percentage, and capital returns participation. The last level, the Common Equity – Class C, carries the highest risk and lowest returns because they receive cashflow after other tiers. An example of payout at this level might be 30% of the 70/30 split and capital returns after the sale in exchange for a $50,000 investment.
Conclusion
The capital stack and waterfall schedule are outlined in the Private Placement Memorandum (PPM) for potential investors and may vary from deal to deal. Understanding the capital stack and distribution priority can increase confidence in reading PPMs and selecting real estate syndication deals that align with investing goals. To discuss upcoming deals, the investor must understand their goals and determine favorable capital stacks. The investor has a couple of deals with different tier structures and can direct them towards the one that will move them more efficiently towards their goals. This will help them select the best deal for their investment needs.