There are plenty of reasons why real estate investors might use
“leverage” — other people’s money — to earn a higher return on their own
investment.Investment property financing is tricky, but this post will help you
navigate investing and the capital stack.
Potential
routes abound when one is trying to raise money for a project. The kind of
money a sponsor or borrower gets might be as important as the total
funding it’s able to line up — because different money means different
things.
Real
estate professionals speak in terms of the “capital stack.” This refers to the
different layers of money and the various strings attached with each layer.
Generally speaking, as one moves up the capital stack, one
enters zones of increasingly higher risk — but also potentially higher rewards.
The chart below indicates the three major layers of the stack — think of it as
a money pyramid.
The three major layers of the capital stack
Senior debt: This
is the bank, or someone acting like the bank, who has to be paid back no matter
what. If a borrower doesn’t keep up with payments, the lender will utilize the
security interest that it likely demanded as a condition of making the loan —
the mortgage — to foreclose on the property and essentially take away
everything that the sponsor and borrower has worked for.
Equity: This is
the true ownership position. Owners get all the upside if the property
appreciates in value, but also take the “first loss” if things go wrong. This
could be the investor by himself or herself, or else he or she might try to
syndicate — share — pieces of the equity piece with others.
Mezzanine financing: This is
an in-between space that can sometimes be pretty interesting for both sponsors
and investors. Mezzanine financing is a kind of debt (though it’s often
structured as preferred equity), but it comes in second after the
senior loan.
This position is a bit riskier for financiers to be in, but the
return rates are generally higher to compensate for that risk. If the project
looks promising enough, then the higher returns usually associated with this
level of the capital stack might well be worth the increased risk.
How does it all work?
For active investors and
sponsors looking to raise money for a real estate project, senior debt is the
cheapest source of financing.
Lenders here, however, will not only want the senior position on
the mortgage but will usually only loan up to 60 to 70 percent of the
property’s purchase price to give themselves a hefty cushion of equity or other
financing positions that, in a downturn, will be hit first.
This financing gets a sponsor a good portion of the way there,
but the remaining amount of needed funds might still be too much for the
sponsor to handle alone.
Mezzanine financing might get a sponsor most of the way to the
reminder of the money needed, but it’s usually more expensive than senior debt.
Because it’s riskier for the financiers (closer to the top of the pyramid), and
more likely to be adversely affected if the property’s value decreases, the
interest rates will be higher.
Nevertheless, if an investor would rather pay a fixed interest
rate to an investor instead of giving up all of the project’s upside, then
mezzanine financing can be a great way to go.
The equity position keeps all of the project’s upside. Lenders
and mezzanine financiers get their interest rates, but if the property has
significantly appreciated, it’s the equity that reaps those (often greater)
rewards.
However, the equity also bears the first risk of loss.
Oftentimes, even with the other financing raised, a sponsor
might need some help at this level. The sponsor investor can turn to his
friends and family to take a share of the project, or perhaps, turn to one of
the other financing sources that have arisen recently.
Each of these financing layers has different costs associated
with it. It is the sponsor’s job to figure out the numbers, and to see which
combination of financing sources might work best for the particular project.
Lawrence Fassler is the corporate counsel of RealtyShares,
a leading online real estate marketplace.
Original
content Inman news
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