What is equity investment in real estate?
Equity refers to the ownership of an asset. An equity investment in real estate is a form of investing where the investors act as shareholders in the properties or funds that they’re investing in. In other words, an equity investment represents an ownership stake in a certain property or a portfolio of mixed properties.
The Capital Stack in Commercial Real Estate
In order to fully understand the difference between debt investment and equity investment in real estate projects, one has to understand the capital stack structure. Multi-million dollar commercial real estate projects are usually structured in complicated capital stacks.
A project description usually includes the capital stack chart or table. Generally, the lower part of the capital stack represents the senior financing, which is higher in priority when it comes to the right to claim the assets of that real estate project. Vice versa, the higher end of the capital stack represents the lower priority when claiming the underlying assets.
Below is an example of a capital stack chart of a real estate property.
An example of Capital Stake Chart
|Type of Capital||Percentage|
An example of Capital Stake Table
Below is an explanation of each of the four most common stacks of commercial real estate projects. Senior debt and mezzanine debt are considered debts/loans, while preferred equity and common equity are the typical equity investment.
Senior Debt. As illustrated in the chart above, the bottom of the stack is the senior debt. The senior debt in commercial real estate is usually issued by a commercial mortgage bank. That bank would have the safest position because even if the project fails or defaults, the bank has the right to foreclose the property and become its new owner (“loan to own”). As the trade-off for its highest security level, the senior debt holder, the mortgage bank, cannot capture the project’s upside potential in excess of the fixed interest no matter how profitable the project.
Mezzanine Debt. Mezzanine (mezz) debt is a subordinated asset compared to senior debt in a commercial real estate capital structure. In the capital stack, mezzanine debt fits between equity and senior debt. It has higher priority of repayment than equity, but is subordinate to senior debt. Usually, the Mezz’s interest rate is fixed or floating, and is higher than that of senior debt. As for risk, mezzanine debt is less risky than equity assets due to collateral, but more risky than senior debt since it doesn't hold the highest right to claim the project as senior debt, especially when the situation goes bad.
Preferred equity. Preferred equity in commercial real estate is a type of investment asset that fits somewhere between that of equity and debt. As far as ownership rights go, it falls into the category of equity since it has the same ownership rights as common equity. But regarding the right to claim profits, preferred equity holders have a superior position to claim the cash flow and profits than common equity investors.
Common Equity. Common equity in commercial real estate works like common stock holders of public companies. This stack of investors share profits when the project goes well, but suffer a loss, which can even be a monetary loss, when the project goes bad. As for the capital stack, common equity is at the top of the stack which means this type of investor has the lowest priority when it comes to placing a claim on a project’s assets. In the distribution process, only after distributions have been made to all other higher-level asset holders, the common equity investors can start to enjoy their proportionate shares of profits. Regarding risk factors, common equity investors bear the highest risk compared to investors such as senior debt, mezz debt, and preferred equity holders.
For example, in the real estate project ABC’s equity investors are positioned as preferred equity holders, and there was no mezz loan financing. When the project was completed and all units were sold, the senior debt holder, the mortgage bank, was repaid first, followed by the preferred equity holders. Those equity investors would first be repaid their principal investment. They would subsequently be entitled to distribution of their fixed preferred returns as provided for by the contracts. Finally, equity investors would then be able to share the remaining profits with project owners based on their proportionate shares.
Pros and Cons of equity investment in real estate
As discussed above, in a typical capital stack in commercial real estate, risk is increased when moving up the capital stack, and in return, the potential of earning higher profits increases as well. Vice versa, risk is decreased when moving down the capital stack, but, in return, there is little room for maximizing returns.
For example, the senior debt holders are usually only entitled to a fixed annual interest rate return. On the other hand, equity investors, and especially preferred equity investors, are entitled to capture the profits for both interest repayment and profit sharing.