Introduction
Real estate is an “other people’s money” (OPM) business, and commercial real estate investors often spend a significant amount of time raising capital for individual deals. This capital comes in two forms: debt and equity. In this post, we will look at how commercial real estate investors raise both equity and debt capital.
Equity Financing
Most commercial real estate investors bring in equity partners to help fund their deals. In these cases, the commercial investor is called the equity sponsor, and the equity investors are called the limited partners.
Real estate deals which rely on outside equity investors must follow the rules of securities issuance as outlined by the Securities and Exchange Commission (SEC). Essentially, the real estate sponsor relies on an exemption from costly registration under the Securities Act. In a previous post, we discussed how the JOBS Act, passed in 2012, expanded these exceptions. Most real estate sponsors rely on Regulation D of the Securities Act. The two key registration exemptions under Regulation D are section 506(b) and section 506(c). Under both exemptions, the sponsor targets accredited investors – i.e., investors meeting certain net worth or income thresholds. However, as discussed in a previous post, real estate sponsors are increasingly bringing non-accredited investors into deals via the additional exemptions under the JOBS ACT.
Regardless of how the sponsor structures the equity, most deals structures follow a similar outline. The two parties, the equity sponsor and the limited partners, operate under an agreement which specifies how the investment will be managed and how the profits will be allocated. This splitting of profits between the sponsor and investors is called the waterfall.
Why do investors put their money into real estate deals? Limited partners expect a fair return on their money. In other words, investors want to be compensated for the risk they are taking by investing in the deal.
Commercial real estate deals can generate returns for investors in three primary ways: cash distributions, property appreciation, and loan amortization.
In an earlier post, we defined a property’s cash flow as net operating income less money set aside for capital improvements. Most of this cash flow is used for debt service (discussed below). Any cash left after debt service can be distributed to the property’s equity investors. Investors look at this cash distribution relative to their total equity investment, a measure called the cash-on-cash return. For example, if an investor has made a $50,000 equity investment and receives distributions for the year of $3,000, the cash-on-cash return is 6%.
The second source of investment returns is property appreciation. Property appreciation generally comes from two sources: higher NOI and/or lower capitalization rates. Higher NOI is driven by the market in which the property is located. If the property is in a growing market with relatively tight supply, NOI should be materially higher over time. Lower capitalization rates are driven primarily by market interest rates. Recall that the capitalization rate is the divisor in the basic valuation formula, so if rates decline, property values increase. Of course, this is not a given. Rate declines are more likely if rates are relatively high at the time the deal is made. The combination of NOI growth and lower capitalization rates can lead to significant capital appreciation.
The third primary source of investment returns in commercial real estate is loan amortization. Loan amortization refers to the spreading-out of the loan’s principal over the life of the loan. If the property valuation stays constant or increases, then every dollar of principal reduction increases investors’ equity.
As an added benefit, investors may also realize significant tax benefits. Entities that hold real estate pass profits or losses through to investors for tax purposes. These entities deduct interest expense and depreciation and may actually pass through a loss as the investor realizes a positive cash flow from the property. In addition, the deal may be structured to defer capital gains.
The primary measure of total equity return on commercial real estate deals is the internal rate of return (IRR). To calculate the IRR, the sponsor creates a forecast of all of the expected cash flows flowing to the equity holders over the expected holding period, including the proceeds from a sale of the property. The IRR is the rate which equates the initial investment with the present value of the cash flows. This rate must be found through iterations, so the equity sponsor will use a financial calculator or spreadsheet software to calculate the IRR.
The sponsor will provide these calculations in the offering package given to prospective investors before they invest in the deal. Limited partners will look for an IRR that adequately compensates them for the deal’s risk.
Debt Financing
The sponsor will obtain the majority of the financing for a commercial deal from a commercial mortgage, in other words, from debt capital. This mix of debt and equity capital is called the capital stack. The capital stack usually contains 25%-30% equity and 70%-75% debt, although deals can vary in their capital mix.
The debt capital is obtained from a bank or a financing company, who will then place a mortgage lien on the property for the duration of the loan. The debt is the thus senior to the claims of the equity holders.
Unlike equity, debt does not participate in any capital appreciation or increase in cash flows. Rather, the lender is solely compensated through the contractual interest rate the borrower must pay the lender. This interest rate may be fixed over the life of the loan or variable. A variable interest rate is tied to a base rate, such as the prime rate, and will reset at regular intervals as the base rate fluctuates.
Most commercial real estate mortgages are amortized. This means that each payment will consist of interest and principal, allowing for the loan to be paid back over the life of the loan. The loan may also contain a balloon payment, where the loan balance must be paid back before it is fully amortized. Loans with balloon payments can introduce significant refinancing risks to the deal, as credit conditions may deteriorate when the balloon payment is due.
Lenders focus on two primary metrics when lending against commercial real estate. First is the coverage ratio. The coverage ratio is calculated by dividing the NOI by the total loan payment. The coverage ratio can also be calculated more conservatively by dividing the property’s cash flow (NOI minus capital expenditure provision) by the total loan payment. These ratios indicate the amount of income available for every dollar of debt service. From the lender’s perspective, the higher the coverage the better.
The second measure that lenders look for is the loan-to-value (LTV) ratio. The LTV compares the loan amount to the property’s appraised value. Lenders prefer a lower LTV as it provides more cushion against a decline in real estate prices.
The Risk of Leverage
The amount of conservatism employed by lenders often depends on the broader credit cycle. When credit conditions are expansive, lenders often lend at higher LTVs and lower coverage ratios. These higher debt levels are welcomed, or even sought out, by many real estate sponsors. Debt financing is referred to as “leverage” for a reason, as it can magnify equity returns. However, debt can also exacerbate losses. Leverage, in other words, works both ways.
Real estate is a cyclical business and overleverage is one of the main sources of failed investments. Great real estate sponsors view themselves as prudent risk managers and navigate their operations accordingly.
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