Who gets paid out first in real estate investing?

August 31, 20215 min read
Who gets paid out first in real estate investing?
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Institutional and wealthy individual investors have understood the benefits of directly investing in private commercial real estate for decades. Real estate can generate regular and reliable income for owners, including during periods of economic stress, as contracts lock tenants into deals that extend for specific periods. With generally low correlations to traditional assets such as stocks and bonds, real estate also offers diversification benefits for a portfolio.

Commercial real estate currently offers return and diversification opportunities in today’s yield-starved environment. As the asset class becomes more accessible, it is crucial to understand the different types of investments, sectors, and sub-sectors within private real estate.

Real estate offers  a broad spectrum of risk and opportunities like any asset class. One key distinction to make regarding investments in this asset class is to understand the differences between exposures in the capital stack. Much like fixed income investing, an investor’s position in the capital structure has significant implications for how they get paid — and the risk they are taking.

Real estate debt versus equity – same property, different return expectations

Real estate investments can be broken down into two broad categories: debt and equity. In commercial real estate, this can be understood as either having exposure to loans or mortgages on the debt side or direct equity interests in real estate or property on the equity side. When investing in loans or mortgages, investors typically expect a return of their invested principal while earning interest over a fixed period, much like a bond.

On the equity side, investors have the opportunity to invest directly – and benefit from such investments, in a property. For example, the equity owner in a real estate deal may generate income from rents and leases while also gaining value from appreciation of property values. Therefore,the potential upside of a real estate equity investment is generally only limited to what a future buyer might pay, whereas the upside of a loan or mortgage is often capped. 

However, equity real estate investments can pose far more significant risks than debt real estate investments, which is why investors seeking exposure to the asset class need to understand how these investments work.

Getting to know the real estate capital stack

In addition to the two broad categories of equity and debt investments, real estate has sub-categories that form a “capital stack.” The real estate capital stack shows investors where they stand in line for repayment or recovery of invested capital if a property encounters financial difficulty.

Mortgage – mortgages are the most conservative real estate investment. Mortgages are the first priority for repayment in a downside case and are typically secured by the real estate itself. Therefore, yields on mortgages are also typically the lowest versus other forms of real estate debt as they are the safest position in the stack.

Mezzanine debt – mezzanine debt is secured by an interest in the entity that owns the real property or equity, not the real estate itself. Real estate borrowers use mezzanine debt as another financial tool for acquiring or improving the property. The rates on mezzanine loans are generally higher than mortgages, as they sit below mortgages in the capital stack.

Preferred equity – entities that acquire real estate may issue preferred equity to lenders as an incentive or issue preferred equity to other investors. Preferred equity gives the lender or entity direct ownership interest in the property, and these positions, while junior to the debt, are senior to common equity, which typically doesn’t have voting privileges.

Equity – equity holdings are direct ownership of the real estate or property and are the riskiest in the real estate capital stack, but potentially the most profitable as there are no direct caps on potential gains.

Real estate equity opportunities

Investors considering allocating a portion of their investments to commercial real estate equity can gain exposure to a number of commercial real estate property types, ranging from multifamily housing developments to warehouses and hotels, among many others.

Investors typically gain exposure to real estate equity deals through a limited partnership structure. The LPs can generally access anywhere from 10-20% of the total equity of a deal. Targeted returns can range dramatically, depending on the type of real estate acquired, expected ongoing costs, and amount borrowed to make the purchase. As these are private investments, there is a liquidity consideration, as invested capital will typically be subject to a lockup over a period of time.

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Finding the right real estate manager

Private real estate investing offers investors many opportunities in the current market to earn compelling risk-adjusted returns. In addition to providing yield and return opportunities, real estate can serve as a valuable hedge against inflation and a potentially reliable cash generator during an economic downturn.

Given the wide dispersion of returns and risks inherent in real estate investing, however, investors should seek a partner that has deep experience in real estate due diligence and underwriting property loans. Managers with experience on the debt side — those who make loans or invest in mortgages — have an up-close view of the different property types, markets, and market participants, giving them an information edge in a market that is inefficient from a return perspective and highly idiosyncratic. Real estate trends can change instantly – as the pandemic has proven. Partnering with the right manager can be  essential for understanding the risk and return characteristics of these investments.

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