The Capital Stack: Debt Versus Equity Investing In Real Estate

As a real estate investor since 2003 and a private real estate investor since 2016, I've learned that understanding the capital stack is crucial to making smarter investment decisions. By grasping the nuances of debt versus equity investing in commercial real estate, you'll be better equipped to invest in a risk-appropriate manner.

Most individual investors buy physical real estate, hoping the property's equity appreciates over time. In doing so, we assume all the risk and stand to gain all the reward—or endure all the loss. However, if you're more risk-averse, you might consider investing in real estate debt instead. Essentially, this approach allows you to act more like a lender, earning returns with potentially lower risk.

If you're planning to invest in private real estate through a leading platform like CrowdStreet, understanding your position in the capital stack is essential. It influences when and how you get paid, as well as the level of risk you're taking on. Let's dive deeper into the distinctions between debt and equity investing in real estate and wrap up with some practical takeaways.

The Capital Stack: Investing In Real Estate Debt

At its core, “debt” means borrowing money with the promise to repay it, along with interest, while “equity” involves raising money by selling ownership stakes in a property or venture.

As a debt investor in a real estate deal, you're essentially acting as a lender to the sponsor managing the project, similar to how a bank lends you money to buy a house. The loan is typically secured by the property itself, and in return, you receive a fixed rate of return—often paid out monthly—based on the interest rate and your investment amount.

Debt investors are prioritized for repayment, meaning they get paid regardless of how well the property performs. Think of it like owing your mortgage lender monthly payments, even if your rental property sits vacant. The obligation to pay back debt remains regardless of income fluctuations.

Because of this priority status, debt investments generally carry lower risk but also yield lower returns compared to equity investments. In the event of a default, debt investors often have the right to recover their investment through foreclosure. In some cases, there may be additional safeguards, such as personal or corporate guarantees from the sponsor, offering extra protection.

The Capital Stack: Investing In Real Estate Equity

Equity investors, on the other hand, are essentially shareholders in a specific property and your stake is proportionate to the amount you invested. Most online real estate investing platforms give individual investors the chance to become equity investors.

Some platforms, like CrowdStreet, focus strictly on bigger real estate projects like apartment buildings, medical offices, or industrial warehouses mostly in 18-hour cities. 18-hour cities are faster growing cities with real estate valuations at reasonable prices. Think Charleston, South Carolina.

The sponsors behind those deals are often looking to raise millions in equity from investors. Returns are then realized as a share of the rental income the property generates or a share of any appreciation value if/when the property sells. The riskier the project, the bigger the targeted returns to equity investors.

Understanding The Capital Stack

The whole point of investing is to earn returns in a risk-appropriate way. When it comes to private equity investing in real estate (going directly to the sponsor and not into a public REIT), the kind of investor you are determines when you get paid.

Much like Maslow’s hierarchy of needs, there is a hierarchy in a private equity capital structure that determines the order of distributions.

The higher you as an investor sit in the capital stack (the equity positions), the less likely it is for you to receive distributions. The probability of receiving distributions at the higher positions in the capital stack can also vary dramatically.

A capital stack has a priority of payment as follows:

Here is how investors in each layer of the capital stack receive distributions. This is a key component when considering debt versus equity investing in real estate.

Receiving Distributions As A Debt Investor

Senior Debt: The most senior of all forms of capital in the stack, senior debt is typically paid monthly or else the borrower risks going into “default” and senior debt holders can seize control of the asset and/or seek recourse from the borrower.

Senior debt has to get paid regardless of how much income the property is generating. Because it’s repaid first, senior debt usually receives the lowest returns relative to the other layers of the stack. But it typically has the greatest certainty of income. For most business plans, this is the safest spot to invest. 

Mezzanine Debt: While still debt (meaning the borrower has an obligation to repay it), this form of debt is subordinate to senior debt. Its interest is paid only after the senior debt receives its interest payments. Mezzanine debt, however, must be paid prior to any other equity distributions. Targeted returns for mezzanine debt vary depending upon the level of leverage and risk involved in the deal.

In cases where the capital stack includes both mezzanine debt and preferred equity, mezzanine debt typically carries payment priority over preferred equity and consequently offers a lower rate. 

Receiving Distributions As A Equity Investor

Most online real estate investing options available to individual investors on platforms like CrowdStreet fall into one of the following equity categories:

Preferred Equity: Preferred equity is not considered “debt,” which means there is no longer an obligation of the borrower to repay it. Preferred equity investors receive their share of distributions once debt service is paid but before payment is made to common equity investors

Common Equity: The top layer of the capital stack, distributions to these investors come after debt service (both senior and subordinate) is paid, preferred returns to preferred equity investors are paid (if they exist), and any reserves are funded for ongoing capital expenses. It’s important to remember that distributions to investors in the common equity layer are made at the sole discretion of the sponsor.

Here is the capital stack flipped upside down from lowest risk to highest risk.

Why Do Real Estate Developers Want Investor Equity?

One word. Leverage.

Leverage is the total amount of debt financing on a property relative to its current market value. It includes all of the different layers of debt in the capital stack. Real estate owners and developers often rely on leverage as a means of increasing the potential return on investment.  

Two Examples With Different Return Outcomes

Let’s say a sponsor has $1 million in equity to invest, and they put 50% leverage on a property. This structure allows them to buy a $2 million retail building ($1 million in equity and $1 million in loans).

They could either put up the full $1 million in equity themselves or raise $500,000 from individual equity investors. If the sponsor raises money, they are only investing $500,000 of their own capital into the project.

Alternatively, the sponsor could also use that same $1 million ($500,000 in investor equity and $500,000 of their own) and might decide to use 75% leverage to buy a $4 million office building. From a capital stack perspective the two deals look like this:

Greater Returns With Greater Leverage

Let’s says that in the first year both properties appreciated by 10% and the sponsors decided to sell.

Even though the two sponsors had the same amount of equity to start and both experienced the same percentage of property appreciation, the first sponsor makes a gross profit of $200,000 (sale price of $2,200,000 minus original $2,000,000) on the transaction.

That is split 50/50 between them and their investor base, meaning they ultimately earned $100,000 on the project. A $100,000 return on $500,000 invested is a 20% gross return before fees.

Meanwhile, the second sponsor made a gross profit of $400,000 (sale price of $4,400,000 minus original $4,000,000), which they split with their investor base, netting them $200,000 for the same initial investment. A $200,000 return on $500,000 invested is a 40% gross return before fees.

In simple terms, leverage enables sponsors and investors to get a higher return in a successful deal. Of course, if a deal does not work out, leverage works in the opposite direction. Higher leverage translates to higher risk.

In essence, where you invest in the capital stack will depend on your risk tolerance and your financial gals.

Equity Steps In When Debt Lending Slows Down

When the market shifted and property values dropped during the Great Recession, borrowers found themselves underwater right at the point their debt matured. They still owed that $3 million but the building might have only been worth $2 million, instead of the original $4 million they bought it for.

The subsequent deleveraging of commercial real estate in the aftermath of the downturn created a need for higher percentages of equity in capital formation. Simply put, if banks were less willing to loan or not willing to loan as much, sponsors needed to raise more equity from investors. This shift to the use of greater amounts of equity helped propel growth for real estate investing platforms such as CrowdStreet.

When COVID first hit, a lot of institutions pulled back on their lending, allowing individual investors to fill those gaps. CrowdStreet actually had its best year on record in 2020. Thousands of investors ultimately invested over $600 million into the real estate deals on its platform.

Post-pandemic, he demand for real estate is still strong, despite higher mortgage rates. The economy is booming, stocks are at record highs, and pent-up demand is growing. With mortgage rates expected to decline by the end of 2024, investors are trying to find good deals now as we've past the bottom of the real estate market.

Skin In The Game Matters

During a real estate bull market, we tend to want to have as much equity exposure as possible to potentially earn the greatest return possible. However, I encourage everyone to stay disciplined and focus on your financial objectives. Run the numbers to account for multiple scenarios (good, normal, bad).

An equity IRR target of 15% sounds very attractive compared to a debt IRR target of 7% over a five-year period. However, ask yourself what are the chances the property isn't sold for a profit?

If the property is sold at close to cost in the future, the equity IRR may be 0% while the debt IRR may be 7%. If the property is sold at a 20% loss, equity investors could get wiped out depending on the amount of leverage.

Ideally, you want to invest in a deal where the sponsor has as much skin in the game as possible.

The Sponsor's Investment Amount In Each Deal Is Important

In the above example, if the sponsor only invested $100,000 of its own money and raised $900,000 in equity and $1 million in debt to buy a $2 million property, I'd probably pass.

However, if the sponsor put up $500,000 of its own money and raised $500,000 in equity and $1 million in debt for a $2 million acquisition, I'd feel much more comfortable. Of course, that's unlikely to happen. Most sponsors will put up between 10% – 20%.

After all, if banks want borrowers to put 20% down before qualifying for a loan, shouldn't we investors demand the same from our sponsors? I think so. The more skin in the game from the sponsor, the better.

Invest In Real Estate Wisely

Now that you better understand the capital stack and its importance when investing in real estate, it's time to do research on individual deals. If you're interested in investing in private real estate equity or debt deals, check out CrowdStreet.

CrowdStreet was founded in 2013 and offers individual real estate deals by sponsors and the occasional fund offering. The firm primarily offers investments in 18-hour cities with generally faster growth, but more attractive valuations. The demographic trends towards lower-cost areas of the country is accelerating. Take advantage.

CrowdStreet is a content partner of Financial Samurai.

This article was written by an employee of CrowdStreet, Inc. (“CrowdStreet”) and has been prepared solely for informational purposes. CrowdStreet is not a registered broker-dealer or investment adviser.  Nothing herein should be construed as an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. This article is not to be relied upon as advice to investors or potential investors. It does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. All investors should consider such factors in consultation with a professional advisor of their choosing. The Capital Stack is a FS original post.