An Overview on Structuring Debt & Equity

While adding value to your investment property is critical to maximize returns and often to protect your downside risk, it is arguably even more important to structure the right deal in the first place. The key components to structuring the right deal are the price, debt, and equity. Price is somewhat more straightforward and requires proper and diligent underwriting to uncover the appropriate price to pay for an asset. To learn more about underwriting, you can find my book, The Definitive Guide to Underwriting Multifamily Acquisitions on Amazon.

The next steps beyond evaluating price and the income and expenses of the property as well as the business plan projections is to incorporate debt and equity assumptions. Virtually all commercial real estate utilizes debt to enhance returns and improve deal structure. Debt must be conservatively factored into one’s analysis of structuring the best deal for them and equity returns must be evaluated on a risk-adjusted basis. Adjusting returns for risk simply means to evaluate returns within the context of the risk associated with potentially achieving said returns.

Debt is one of the largest factors when it comes to risk, so it is important to understand how the leverage, interest, and term of the proposed debt structure impacts the overall risk of the investment. Higher leverage loans may increase projected returns, but also increase the risk of losing money in a downside scenario. Higher leverage is usually accompanied by a higher interest rate, which negatively impacts cash flow and could put the investment in a negative cash flow scenario if the business plan targets are not achieved. Floating rate debt and fixed rate debt also carry their own respective risk factors. Floating rate debt can negatively impact cash flows if interest rates rise during the ownership of the property. Meanwhile, fixed rate debt can adversely affect a sale since fixed interest rate loans usually have a very strict and expensive prepayment penalty.

Finally, the term, or duration, of the investment’s loan is also a risk factor since a shorter-term loan can create a scenario where the loan becomes due at a time when the property’s value is such that it is unable to obtain new financing to pay off the existing debt. A situation like this can force a sale at the exact worst time, which may cause equity investors to lose some or all their initial investment.

On the equity side, investors must also ensure that their deal is properly structured to align interests between the sponsor and investors. Both sponsors and investors should seek to structure / participate in a fair deal with an appropriate fee load as well as a fair performance compensation structure, otherwise known as a waterfall. An acquisition fee is a fee paid at closing to the deal sponsor, or the individual / company responsible for putting the deal together and managing it after closing. Acquisition fees should almost always be between 1% and 2% of the purchase price of the property. Anything greater than 2% should be justified via a unique strategy or value proposition. Asset management fees are ongoing and are usually 1% to 2% of the property’s revenue. It is important for an investor to understand the deal’s entire fee structure and ensure it is fair when evaluated in its entirety.

The best deal structure includes a preferred return which provides equity investors a minimum level of return prior to sharing in any of the profits with the sponsor by way of a performance compensation, or promote. Sponsors should be incentivized to outperform the preferred return which is usually 6% to 10% so they can make money through their promote based on the waterfall. The most common waterfall in multifamily investments is an 8% preferred return followed by a 70 / 30 split (70% of remaining profits owed to investors and 30% of remaining profits paid to the sponsor as their promote compensation). There are additional nuances related to preferred returns, waterfalls, and control rights within equity partnerships which are outside the scope of this article.

To learn more about not only structuring the right deal, but raising the debt and equity for your next project, check out my book, Structuring and Raising Debt & Equity for Real Estate on Amazon.