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Understanding A Waterfall and Capital Stack In Passive Real Estate Investments

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Passive Real Estate Investments

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Jargon permeates most industries and passive real estate investments are no exception with their share of keywords and tricky phrases. The order in which distributions are paid in a passive real estate investment is described in the structure of the capital stack or “cap stack” for short. Clarity on this concept as an investor is critical to understanding where your investment falls in order of priority for returns. Often, the process of how the capping stack is distributed is referred to as a “waterfall.”

There you go, cap stack and waterfall. Inside, we’ll share what these mean and why they are important to you.

Passive Real Estate Investments: The Waterfall

Imagine a list of everybody participating in a deal with debt and equity partners categorized into groups – those with the lowest risk and potentially lowest returns at the top. When cash flow is available, it gets distributed like a waterfall, starting at the top group and if there is enough water, trickles down to those with higher returns and taking a higher risk at the bottom.

The structure of how this works is outlined in the Private Placement Memorandum (or PPM) that each investor signs at the beginning of the deal. It explains who, how, and when each class of partner (whether general or limited) gets paid during the life of the deal.

Some classes can receive the only cash flow, while others participate in cashflow distributions and capital returns profits when sold or refinanced. As an investor, you need to understand where you are in the pecking order and how it will help you achieve your financial goals. Do you desire monthly cash flow? Or are you targeting capital appreciation and winning big on the exit? Or are you looking for a little of both?

Keep in mind that you are likely going to be some category of an equity investor, not a debt investor like the bank holding the mortgage.  Mortgages get paid first, almost always. And, cashflow distributions are always paid out after expenses, fees, and debt payments on the property.

The Capital Stack

When you invest, do your homework on the property, vet the sponsoring team and make sure you understand who gets paid what, when, and why so there is no confusion. The capping stack in a real estate deal outlines the rank order in which those people who put money in the deal get paid and how. The highest priority, lowest risk partners are at the top, and the lower priority, highest risk partners are at the bottom.

Every deal is structured differently, but below are typical categories.

At the top, you’ll always have what is called Senior Debt.  This includes mortgages and loans to finance the property. Just like you would never miss a house payment, senior debt is the highest priority and gets paid first. Mortgage-type loans have a lower return (3-5% for the past several years) in exchange for being a top priority.

Going down the waterfall on the capping stack, preferred equity comes next. They are after debt payments but before common equity. After the mortgage, expenses, and fees are paid, preferred equity has “dibs” on distributable cash. Sometimes, preferred equity or “pref” requires a bigger minimum investment or is capped at some aggregate amount because they have a higher projected cash flow than investors lower in the waterfall.

Following preferred equity are common equity that has the highest risk and lowest priority of payment. This group is likely participating in the capital returns and will get some of the cash flow after the preferred investors.

Passive Real Estate Investments: The Impact of the Cap Stack

The capital stack impacts investors in two mains ways; cash on cash and IRR (internal rate of return).

Cash on Cash returns is the before-tax earnings an investor makes on their invested capital and can also be referred to as cash flow or distributions. If you are a preferred unit investor, you may have better cash on cash returns because you are higher in the capping stack and get paid before common units.

IRR means the internal rate of return and measures the deal’s total profitability (cash distributions and capital return profits on sale). It’s a fancy way of calculating your total return while accounting for the time value of money.  A dollar today is worth more to you than a dollar you receive 10 years from now, for example.

When you have a clear idea of how the waterfall on the capping stack treats cash on cash and IRR for each class of units, you can make better investment decisions to support your personal financial goals and achieve them faster.

A typical cap stack and waterfall

Senior debt will be on top carrying the lowest return and the least risk as it ranks top in priority of repayment. Often this mortgage is expressed as a Loan-to-Value or LTV ratio, with 70% being a common benchmark. (for example, a $7M mortgage on a $10M investment)

Next is the preferred equity. This group receives projected cash flow at a targeted percent – say 9% preferred return. Often it is cumulative, meaning that if the 9% cash distribution is missed in one year, the amount missed is held on the books and must be paid before the common shareholders are paid.

The preferred shares often have a feature that is tied to the IRR. Once the 9% per year payment has been satisfied, then any bigger annual distribution of cash and any capital returns profits on sale are split with the common shareholders. For example, anything cash or capital return above the 9% is split 70/30 with the common equity, with the preferred receiving 70%.

Finally, then, the common equity is the highest risk and last in line for payout receiving 30% of profits after the debt and preferred terms are satisfied. Often this common equity is owned by the sponsor and is vested with them as part of their compensation for arranging the deal. Thus, they are willing to be last in the payment stream because they may not have invested cash to receive the shares.

Passive Real Estate Investments: Conclusion

The capital stack and waterfall are always outlined in the PPM (private placement memorandum), and you should always read and understand it before investing in any deal. The examples in this piece are simple illustrations, the actual structures of waterfalls can have many more complicated features such as a 70/30 split from an IRR of 9%-14% and then a 50/50 split for an IRR greater than 14%, effectively incentivizing the sponsor to do maximize profits for everyone.

Now that you have a basic primer on how investments are made and money repaid, read the next PPM with the confidence knowing you can ensure it fits your investing objectives.

For more information, don’t hesitate to contact us today.

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Understanding A Waterfall and Capital Stack In Passive Real Estate Investments

Passive Real Estate Investments

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