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Understanding The Capital Stack In A Real Estate Syndication Deal

by | Jun 15, 2021 | 0 comments

The order in which distributions are paid in a real estate syndication investment is called the capital stack, and your clarity on this concept is critical because you need to know where you fall in order of priority for returns. 

If you invest at a Class B level and Preferred Class A investors receive distributions first, you want to know how that all works and how the syndication structure impacts your returns and risk levels.

Understanding the waterfall effect in which returns are paid in a real estate syndication will also allow you to select real estate investment syndication deals in which the capital stack is favorable toward your investing goals. Your knowledge of the risk and priority at each tier is a vital piece of knowing why and when you’ll receive distributions. 

Inside, I’ll share what the capital stack is, why it’s essential, and how it impacts you. 

The Waterfall

The way the capital stack works is called a waterfall. Imagine a list of everyone participating in the deal with the debt and equity partners categorized into groups – those with the lowest returns and the highest risk at the top. When cashflow is available, it gets distributed like a waterfall, starting at the top and trickling down to those with higher returns and lower risk toward the bottom.

A waterfall structure is outlined in each deals’ PPM (Private Placement Memorandum) at the beginning of a deal. It explains who, how, and when each partner, whether general or limited, gets paid during the real estate syndication deal. 

Some classes receive only cash flow, while others participate in cash flow distributions and capital returns profits when the property is refinanced or sold. So, you want to understand where your potential investment is in the waterfall structure and know which pieces apply to you and how they might help you toward your financial goals. 

  • Are you solely focused on creating passive income in the form of monthly or quarterly cash flow? 
  • 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 cash flow 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, cash flow distributions are always paid out to the limited partners after expenses, fees, and debt on the property. 

The General Partners also known as the sponsor or syndicator are generally paid after the Limited Partners are paid their proper investment returns.

The Impact

The capital stack affects investors in three main ways: 

  • Cash on cash
  • IRR
  • Velocity

Cash on cash returns is the before-tax earnings an investor makes on their invested capital, also referred to as cash flow or distributions. If you’re in the preferred tier, you may have more significant cash on cash returns because preferred investors have a higher priority, thus get paid first but these preferred investors often receive none of the upside in the deal.

IRR means Internal Rate of Return and is a metric to measure the deal’s profitability (cash and equity). It’s a fancy way of calculating your return while accounting for the time value of money, a concept that holds today’s money more valuable to you than that returned to you in the future. 

Velocity is your ability to invest in more deals at a faster rate. As an example, when a deal gets refinanced, you may get some capital back if you’re participating in a capital returns position (not everyone gets their capital back – more on that in a minute). You can take that returned capital and invest in another project. This way, you’re effectively getting returns on two real estate syndication deals when maybe you only had enough for a single deal to begin with. 

Suppose you have a clear idea about each of these concepts and how each position in the waterfall or capital stack impacts each class. In that case, you’re able to make better investment decisions to support your personal financial goals and achieve them faster. 

The Capital Stack

As an investor, you always want to do your own research on the property, vet the sponsor team, and you definitely want to know who gets paid what, and when each payout is supposed to happen. It’s nice to know what to expect and be utterly comfortable upfront so there’s no confusion as to when you’re getting paid, right?

Well, the capital stack in a real estate syndication investment is where debt and equity partners are ranked in order based on an inverse relationship between risk and priority. The highest priority, lowest risk partners are toward the top of the capital stack, while the lower priority, higher-risk partners are toward the bottom. 

At the top, you’ll always have what we call Senior Debt. This includes mortgages and loans to finance the property. Just as you’d never miss a house payment, the senior debt is the highest priority, and they get paid first. Mortgage-type loans typically have a meager rate of return (2-4% for the past several years) in exchange for being top priority.  

Next, there are second-level, mezzanine-type loans like second mortgages and bridge loans. These are also debt positions and are ranked as a higher priority and lower risk than our limited and general partner investors. 

Continuing down the waterfall, you’ll see preferred equity (limited) partners come next. These investors are often labeled as Class A in investment summaries. They are prioritized after debt payments but before the other limited partners and the general partners. After the property mortgage, expenses, and fees are paid, preferred investors have “dibs” on distributable cash flow. There may be a higher investment required at this tier, and there are limited positions available at this level. Still, preferred investors often have a higher projected cash flow than other investors down the waterfall. 

After the preferred equity investors come the limited partners who receive any cash flows after the debt and preferred equity partners are paid. These investors are often labeled as Class B investors in the investment summary. These cash flows are generally smaller than those paid preferred equity investors BUT these limited partners also get a share of the profit on sale. These limited partners often receive a higher overall return than the preferred equity investors.

There are two main types of capital stacks – single and dual-tier. Just as you might imagine, the dual-stack is a little more complicated.

Single-Tier Stack

In a typical single-tier stack, Senior Debt is at the top, carrying the lowest risk and ranking highest in priority. A great example of this is a mortgage at an approximate ~70% loan-to-value ratio. 

The next level in a single-tier stack is Common Equity – the Limited Partner investors. They may receive a preferred return (typically 6% to 8%) and then receive a 70% share of all cash flow and profits from sale moving forward. The preferred return is not guaranteed but the limited partners receive their preferred return before the general partner receives any portion of the cash flow.

Dual-Tier Stack

The dual-tier stack is a little more complicated. Still, it’s becoming more popular because this waterfall structure can provide higher cash flow to class A investors while the Class B investors typically receive a higher overall return than the Class A investors.

First up again is the Senior Debt and includes any mortgages or loans on the property. After this is where it gets fun!

Next, there’s a Preferred Equity – Class A level. This group receives projected cash flow at a preferred return only. This might be 9-10%, for example, but they receive no share of the upside. This is perfect for investors who are only looking for consistent cash flow distributions. One caveat might be that this Class A Preferred Equity status likely comes with a more considerable up-front investment with limited shares available. For example, less than 30% of the deals’ shares might be available for a minimum $100,000 capital investment.

After the Class A level, you have the Common Equity – Class B investment level, which may include preferred returns, splits beyond the preferred percentage, and capital returns participation. For example, maybe a $50,000 capital investment would earn a projected ~ 7% preferred return, 70% of the 70/30 split, and capital returns at the sale. Class B investors shoild anticipate lower cash flow but higher overall returns.

As a side note – in my personal syndication LP investments, I have always purchased the Class B shares because I want the higher overall return. This is what I consider best for my personal life stage and investing goals. This does not mean it is the right decision for you. At Spark Investment Group, we help our investors figure out which approach is best for them.

 

Conclusion

As always, the capital stack and the waterfall schedule are outlined in the PPM (private placement memorandum) and are available to you as a potential investor before you commit to the deal. But, the PPM details might seem like gibberish if you aren’t clear on the capital stack, how it works, or where you fall in priority for distributions. 

Now that you have a solid explanation and a few examples, your confidence in reading any PPM and selecting a real estate syndication deal that is in alignment with your investing goals will skyrocket!

I’d love to share upcoming deals with you, but first we need to talk so I can hear about your investing goals and help you determine capital stacks that will be favorable for you. I have a couple deals in mind with different tier structures and would be happy to help direct you toward the one that will move you toward your goals more efficiently. 

Join today at the Spark Investor Club and get the “inside scoop” on our past and upcoming deals. Once you apply to join the club, I’ll get on a call with you so we can see if we’re a good fit to invest alongside each other on any future real estate syndication deals! I can’t wait!

To learn more about real estate investing and syndications, reach out to us at https://investwithspark.com/contact/ today!

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