Real Estate Equity Investing: What, Why, & How

Real estate, similar to all other investment classes, requires thoughtful consideration of risk-adjusted returns. The higher the degree of risk, the more yield or return one should expect (and vice versa). However, the more inherent risk to an investment, the higher the potential loss could be as well. Balancing your risk tolerance relative to your return expectations is foundational to all asset classes. This article takes a look at real estate equity investing, and considerations for the self-directed investor.

As we will discuss, there are numerous legal and payment structures within real estate investing that can impact a specific investment’s risk profile. Additionally, a real estate investment’s strategy, property class, business plan, market, borrower or sponsor, and other attributes of a project all significantly impact the risk-adjusted return.

This article takes a deeper dive into certain ways real estate equity investments can be structured, and some key benefits and considerations for individual real estate investors.

Real Estate Equity Investments—The Basics

Real estate investors typically refer to the absolute dollars committed into a project as its “Total Capitalization”. The various stakeholders (debt and equity) provide the “Sources of Funds” and together comprise the real estate “Capital Stack”. The Total Capitalization may go far beyond the purchase of the real estate, and might include: 

• Value-add construction or improvements
• Marketing expenses
• Tenant improvements and leasing costs
• Professional services in furtherance of the business plan

Common equity real estate investments are typically longer-term in nature and subject to varying cash flow distributions, whereas debt (senior and subordinate mortgages, mezzanine debt) or preferred equity is more readily refinanceable and generally has a contractual maturity term and a stated interest or payment rate.

A building is a useful metaphor for the real estate Capital Stack—the total committed dollars to a project. The equity position is the top floor. Below the top floor sit the lower-upside, lower-risk portions of the Capital Stack, including senior debt (the foundation of the building), subordinate debt (including the aptly-named mezzanine debt), and preferred equity. The lower the position in the Capital Stack (closer to the foundation), the more protections investors typically have. Senior debt is so-called because it is “senior” to all other positions in the Capital Stack (i.e. senior debt holders are entitled to be paid principal and interest before any other investor in a given real estate investment). Subordinate debt and preferred equity investors hold payment priority to the equity investor, and generally have certain rights and remedies (and in other instances recourse) to protect investors in the event of a non-performing or defaulted investment. Equity investors are the last to receive distributions or repayment of their invested capital. Said another way, the equity investor is also the first to lose their money or investment. In exchange for accepting the risk-of-first-loss position, equity investors participate in higher potential upside, which is generally uncapped.

Real Estate Equity—Security Interest/Collateral

Real estate equity investors typically enter into a partnership structure, with the sponsor acting as a “General Partner” or “GP” and passive investors – e.g. individuals investing through EquityMultiple – as “Limited Partners” or “LPs”. In a typical common equity investment offered by EquityMultiple, investors purchase fractional ownership interests in a special purpose vehicle, which provides a fractional ownership interest in a property or properties.

Return Metrics

Preferred equity and debt investments on the EquityMultiple platform carry a stated rate of return that is contractually obligated. A contractual return can be paid currently, accrued (added to the outstanding principal balance and paid with available cash flow or upon a liquidity event—most commonly a sale or a refinancing), or include a combination of both.

Current equity distributions are paid from net operating income (NOI): cash flow generated by the tenant leases at a property, minus operating expenses and debt service. In some instances (development projects, repositioning strategies, lease-up plays, etc.), equity returns could be partially or wholly conditional on a liquidity event (sale, partial sale, or refinance of the property). 

Hence, a time-weighted return—or “Internal Rate of Return” or “IRR”—is commonly utilized to evaluate success and provide a comparable annual metric. Depending on the business plan of a project, metrics such as cash-on-cash return or equity multiple may also be helpful to evaluate an equity investment’s projected and actual performance. For a more detailed discussion of return metrics, please refer to this article.

Distribution Waterfalls and Promotes

Once debt and preferred equity positions are paid, the particular payment arrangement within the equity structure kicks in. These arrangements, often referred to as “Waterfall” or “Promote Structure,” dictate the order and proportions of payment of cash flow, invested capital, and profits among GPs and LPs. These arrangements are contractual and are key for any LP investor to understand in order to evaluate potential investment performance.

In a common Promote Structure, a Sponsor (the GP) usually contributes some percentage of the equity requirement of the Total Capitalization. Often, they will raise third-party capital from LPs for the remaining equity commitment. The GP will earn a share of profits up to a certain threshold—“pari passu” with LP investors—until return is achieved for all equity investors. This first step, or Preferred Return, includes the return of the original investment plus some level of return on the original investment. 

Once this initial Preferred Return is achieved—and all principal is returned, pro rata—the “Promote” of the Waterfall applies, whereby the sponsor typically earns a larger proportion of excess cash flow, refinance proceeds or profits. A Promote is commonly utilized to incentivize the GP to maximize a project’s potential and, as a result, benefit from an outsized return. A Waterfall structure is inherently complicated and could be further complicated with multiple “Tiers” or breakpoints where a sponsor benefits from additional allocations or sharing of proceeds.

Below is an example of a typical Waterfall structure, which would be summarized in EquityMultiple’s Subscription Agreement:

1. First, 100% pro rata to GP and LP until both receive their respective accrued and unpaid 8.0% return on invested capital;
2. Second, 100% pro rata to GP and LP until all capital contributions (principal) are repaid (1 and 2 together, the Preferred Return);
3. Third, 70% pro rata to LP and 30% to GP until all members receive a 20% IRR (the Promote) and;
4. Thereafter, 60% to LP and 40% to GP (the ‘Tier’ of the distribution waterfall).

A couple of things to keep in mind as you are evaluating EquityMultiple investment offerings: a) all target returns are presented net of EquityMultiple fees and b) if you have questions about any particular distribution waterfall, you are welcome to schedule a call with EquityMultiple’s Investor Relations team for clarification.

Real Estate Equity Investments – Past Examples

Why Sponsor Promotes Exist

LPs rely significantly on GPs to execute on many fronts to successfully achieve positive outcomes in a real estate project, including:

• Sourcing and underwriting opportunities
• Leveraging local knowledge and a boots-on-the-ground presence to unlock hidden value (such as implementing repositioning strategies or acquiring property at below-market value)
• Assuming debt
• Formulating and executing on a strong business plan
• Managing tenants—including lease-up, turnover, and lease renewal
• Securing additional financing
• Negotiating and executing asset sales to maximize returns

In addition to the above, GPs typically take on other non-financial commitments and risks born by the GP and not at all by the LP. The Promote structure is intended to compensate the GP for these risks and align their interests to maximize shareholder value for all constituents. EquityMultiple aims to structure favorable distribution waterfalls on behalf of our investors, to properly incentivize GPs to strive for each incremental dollar of return.

Cash Flow, Project Plans, and Varying Risk/Return Profiles

While equity real estate investing generally entails a higher degree of risk and potential reward than more senior positions in the CRE Capital Stack, equity investments vary substantially in their term, target cash flow profile, risk factors, and exit strategy.

Here are some factors to consider when comparing equity investment opportunities:

Market

A strong, established local market and diverse demand drivers may reduce lease-up or re-tenanting risks in a CRE investment, whereas overbuilding and increased competition from other investors may compress rents and cap rates and dampen return potential.

A secondary or tertiary market, with a less established (but growing) set of demand drivers, typically offers higher going-in cap rates and greater potential for significant appreciation. However, without diverse and established demand generators, the market may be harder hit by an economic downturn, increasing potential risk.

Cash Flow 

Strong in-place cash flow from quality, diversified tenants may reduce cash flow volatility. Projects that involve significant lease-up and/or repositioning may entail less certainty or consistency of cash flow. 

Scope of Project 

Less complex and extensive capital improvements and limited development mean less potential for significant delays and cost overruns.

Ground-up projects that entail new construction carry more complexity and, generally, offer little to no near-term cash flow, resulting in a higher degree of risk. However, successful ground-up investments may benefit from growth in a developing locale or capitalize on an underserved property type in a market, and potentially capture outsized returns.

The Big Picture: When to Invest in Equity

As discussed above, the risk/return profile of any equity investment can vary substantially based on various attributes of the investment.

That said, an equity real estate investment may be worth considering if:

• You are comfortable with a lack of liquidity: Your investing goals do not preclude a term of 3+ years with no contractual cash flow.
• You understand the investment’s economic structure: Waterfalls and distributions can be complex in equity investments (as explained above).
• You are long on debt, preferred equity, or non-real-estate fixed-rate investments: Real estate equity investments (just like stocks) can complement, and offer de-correlated from, more traditional liquid investments, and may potentially provide long-term appreciation in your portfolio.

We encourage investors to consider a diversified approach, which includes diversifying across the capital stack and between underlying investment classes. To assist in your analysis we aim to educate our investors on the benefits and complexities of equity investing. We reiterate that all investments have a specific risk profile and return potential. To that end, we want to make sure that the increased nuance of equity investments does not stand as a barrier. Please feel free to schedule a call with our Investor Relations team at any time to discuss further.

Post-Script: Real Estate Equity Investing & COVID-19

The global outbreak of COVID-19 halted construction in many markets, caused massive upheavals in supply chains, and sparked demand dislocations.

Asset repricing as a result of the pandemic will create opportunity across the capital stack, and common equity is no exception. Economic distress will force some operators to liquidate, creating new value-add equity investment opportunities. Historically low interest rates will reduce the cost of debt capital for the foreseeable future, further improving fundamentals for equity investors.