The Capital Stack Series - Key Terms & Sizing

Now is one of the most challenging times in my career to assess what the eventual capital stack will look like, because it is. We're in a very volatile environment.

How do you find out if a buyer has the wherewithal and the ability to transact? They might not want someone to sit behind them because that could actually elevate the risk on the transaction. We have a lot of investors who listen to this show, aspiring investors. We also have a lot of brokers. Brokers, right. And this is also, by the way, everyone helpful when you're looking to qualify that buyer. Welcome, everyone. We are back for the Capital Stack miniseries and here today with my fellow principal Scott Singer, who co heads our debt and equity group here at Avis and Young. Scott, thank you so much for joining us again today.

James, good to be here.

Wonderful. So today we're going to be talking about key terms and sizing. Last time we talked about the role of the debt equity advisor, you know, the timing, when to get involved. How can sponsors and borrowers put themselves in the best position? What if someone's new to investing? So now we're going to actually talk about the keys terms and again, the sizing, how this all works. I mean, maybe we could have done this as the introduction, but at least now everyone has an understanding of at least the how this works. So let's talk about the capital stack. What is it and what are the components to it?

Okay, so the capital stack is a fancy way of saying the money that goes into a deal. So it includes debt and equity. And actually I was just, I'm teaching my daughter who's a freshman in college about, she said sort of what is real estate, what is business? And so we're going through this. So debt and equity together is all the capital that comes into a deal. And then each of those can be broken up in ways that can get quite complicated, sophisticated.

Let's start with equity, right? So that's the cash in. So let's say we've got a sponsor who's looking to purchase a property, and let's say it's a rehab, for example. So they're bringing money to the table for the purchase, the closing costs to reposition. How does that equity kind of lay out?

Okay, let me go back to the beginning of debt and equity. If you think about a house, which is generally the most simple, most people, when they go to buy a house, use a mortgage, which is the debt for a portion. And lenders don't lend 100% in most cases of the money they'll lend less than that so they're in a safer position. And so the portion that you borrow is the debt. And then what you'd call in the house, a down payment is the equity portion. So that's the ownership stake. So in commercial real estate, same basic principles apply. There is virtually always a debt component and the remainder of the capital above the debt is the equity. Now in commercial real estate, as opposed to in most homes, many properties are purchased where the sponsor, the person who is going to work on the deal, who has found it and who is going to be known in the press is the owner, is often using other people's money as well. And so that other people's money who are a part of the ownership and who are counting on hoping for the property to increase in value so that they can get back more when it is sold than they started out with is the equity. Now in a rehab deal, what does rehab mean in a real estate perspective? It means that there's something about the property that can be fixed in order to generate more income or cash flow from the property and a higher value down the road. So groups that want to invest, there's a continuum of risk and return or risk and reward that exists. And so a rehab deal is considered to be riskier than a transaction that already is fully maximized.

Yeah, no, no, that's perfect. And I really appreciate that you kind of took a step back and explained the whole picture because I think sometimes people have tendency to just throw out terms and that may might not understand kind of what goes into that. And I think also we have a lot of investors who listen to this show, aspiring investors. We also have a lot of brokers. Right. And this is also, by the way, everyone helpful when you're looking to qualify that buyer. You know, so how do you find out if a buyer has the wherewithal and the ability to transact and you as the broker, the buyer might say, oh, I'm an all cash buyer. And so I think a lot of this lingo gets thrown around all cash to us doesn't necessarily mean that they're going to close all equity. They might be financing, but what they're trying to say is it's not contingent on their ability to obtain financing.

Yeah, I think one of the. And I'm at this interesting inflection point in explaining the capital world because I have this daughter who's learning about it for the first time and it's made me reassess the terms that we use. And I teach a class at the rebny that's sort of the basics of commercial real estate for residential brokers, many of whom are looking to make the change. And it's a similar dynamic in that the lingo can be very confusing and maybe sometimes intentionally so. Yes, all cash is a perfect example. What you're focused on for your clients is trying to get to the highest price. But then beyond that, in this kind of environment, what is the likelihood of closing? And so a buyer who has all of the capital on hand is the most likely to close in this environment. But when you say all cash, that creates this confusion. We are working on some transactions that we are suggesting to our clients should be done all equity. And that is because as the cost of debt increased and as some of the volatility in the market and other costs increase, debt at a higher rate creates more risk, sometimes in a transaction.

So let's talk about that role. And we also. Sometimes these terms can mean the same thing. So when you talk about a sponsor, you know, some might have heard that called a syndicator, if they're going to actually go out and raise the capital, some might call that also that. That sponsor could also be the general partner, right, where they're actually running the deal on the day to day. And then if they're bringing on additional equity, if they're raising money, typically that's coming from limited partners. So maybe talk a little bit about the general partner role, the LP kind of the interplay between the two and the economics.

Well, I think it's important to remember the distinction between the. If we're talking about a specific transaction that has documentation, whether that's loan documents or an operating agreement, then each of these things will be a defined term and it means something specific in conversation. Then the terms are used in various ways. So I used the term, I think, before sponsor as the person who's out front and running the deal. And that is the name that we would read generally in the press about a new transaction. But within most sponsors now use other people's money. Okay, and so the question then is, how is that? How is the relationship structured between the sponsor person and the investor people? And the various types of money that we may be called on to raise are COGP money, LP money, preferred equity money. All of those could conceptually be equity investments in the property. LP is a term that comes from limited partner in an older investment structure that was a limited partnership. So an lp, by contrast, is generally someone who invests money with a sponsor and relies on that sponsor to run the real estate A GP sometimes implies the person who's making decisions and running the real estate. A co GP relationship can either mean two groups who are sharing the responsibilities for running the property and. Or simply sharing in some of the excess profits that are. That are developed.

Yeah, and I know in a future episode we're going to kind of get into more about that relationship and how that works, decision making, things of the likes. But let's talk about the different type of equity that's out there. So talk about common equity, preferred equity.

Okay. An alternative way of describing various structures would be common equity versus preferred equity and that is relating to the priority. And so I think it might be helpful to talk about the whole continuum of risk from the safest money in a deal in a capital stack that would be great to the riskiest.

And I think we even have an example of this. I don't know if it's in a pyramid shape, I can't remember, but it's in the book and Scott was very helpful in providing the content in the book for this.

I appreciate that. So the safest money would be referred to as senior debt or senior mortgage debt. And we could nuance each level of this, and we probably will in these episodes. But moving from the safest debt being the most senior, and that basically means the first one to get repaid to subordinate debt, which is sometimes in the structure of mezzanine debt, sometimes in the misleadingly named preferred equity, which is often really a debt structure, that subordinate debt level is the next riskiest after the senior debt or senior mortgage level. Beyond mezzanine debt or preferred equity, the next step up would be. Well, some deals have senior mortgage, mezzanine debt, preferred equity as a riskier step above that then common equity is an alternative name generally for LP equity, and that is money that's been invested in partnership that does not have to be repaid. But in using the term LP money, it generally is money that will. That is simply money. It's simply a money partner and it will receive a proportionate share of the returns from the property either after all the debt is paid along the way or at the end and then above that in this structure. By above I mean both riskier and hopefully higher return is co GP money, where the co GP money is either sharing in some of the additional risk with a developer. Sometimes cogp partners share in the guarantees in a project, but they are also sharing in the excess upside. As we dig into equity, we will talk about how equity investors get paid and we'll get into the concept of Promotes and a co GP partner implies that that money investor will receive some stake in both the promotes and the fees that a sponsor is generally earning through their actions.

Now, I guess we preface this or if it's not, it's in the disclaimer check with your counsel. I don't want to get too to the priority here, but you did mention something that preferred equity can look and feel like mezzanine debt. Which begs the question, you know, why would there be a need for both instruments? What's the difference?

Okay, this brings us into a discussion of collateral and security. And so the, in a, in the simplest structure, like we talked about with a house, where there's simply mortgage debt and sponsor equity, the mortgage debt implies that the lender receives. There's a bargain that's made between the borrower, in this case the sponsor and the lender. Where the lender lends the money, the borrower promises to pay it back. And that promises in the form of a note. It's a document that says, here's how much I borrowed, here's how much interest I'm going to pay, any other payments along the way, and here's how much I owe you at the end and when I owe it to you. But the mortgage document is the document that establishes the property as the collateral for the loan. So that if the terms of the note are not lived up to, if the borrower fails to make the payments it's obligated to make, then through a legal process, the lender has the right to force a sale of the property in order to capture whatever value is left in the property. Mezzanine debt is also, I'm not necessarily using the legal term, but it's also secured and that's why it's less risky than equity. But in a mezzanine debt structure, the security comes through a pledge of partnership interest through a ucc. So now we're getting into the real legalese. But a preferred equity investment implies that there are some obligations to pay back the money, but they are not secured by necessarily a pledge of the real estate or not something that's recorded.

Very helpful. And the intercreditor agreement is actually a document that talks about how these priorities work or if they can work. So for example, and we're not saying that in all situations there could even be mezzanine debt. Right. So some lenders, someone say it's a conventional bank that's offering a first mortgage, they might not want someone to sit behind them. Right, because that could actually elevate the risk on the transaction.

Well, the structure that anyone you know less than 20 years in the, in the market won't really have experience would be that the, the traditional form of subordinate debt was second mortgages, right. And third mortgages and fourth mortgages and where a series of parties who had a hierarchical relationship, each of those lenders, even the subordinate ones, had a mortgage interest in the property. So there was the possibility of them forcing a sale of the asset. And in the real estate depression of the early 90s, where many properties declined in value and there were many challenges in foreclosure actions, the fact that the second and third and fourth level creditors had secured obligations created tremendous trouble in allowing lenders to recapture their money and held properties up for a long time. So the result of that was many, many, virtually all first mortgage lenders came into the 90s recovery saying we will not allow second mortgages or secondary mortgages. And so the mezzanine lending structure was created. And then there was a next evolution when during the 2009, 10, 11 challenges, mezzanine lenders still had rights that made life difficult for senior mortgage lenders. And so many lenders then started saying, we don't want to have mezzanine lending behind us. And preferred equity structures were created that were very similar, but without violating the clauses that mortgage lenders were starting to put in against mezzanine. So it's a continuing evolution and it makes the legal profession robust.

Yes, and, and very helpful. And I realize for, for some of you newer to investing, we, we just went from like a Level 100 survey intro course to we, we went into, you know, a, a, a senior thesis. But let's dial it back a little bit and, and talk about how you actually size up an opportunity. Right. So let's talk about again, you, you have a, a borrower. This is typically how it works. They call you up. Scott, I have this property under contract. How much financing can you get for me? So let, let's talk about how you, what, what is that loan to value? How do you determine it? How do you size up a deal to figure out what type of financing that you can achieve and how you're going to build out that capital stack for them?

So the answer is always market driven and it fluctuates tremendously over time. And now is one of the most challenging times in my career to assess what the eventual capital stack will look like because we're in a very volatile environment. The traditional metrics that are used to size senior mortgage financing are debt service coverage, loan to value loan to cost and more recent, but it's over the last 10 years. Debt yield. And so I'll start with debt yield because it's maybe the most confusing. Debt yield sounds like it should be related to pricing, but it is not. Debt yield is a sizing concept and it is the relationship between the net income at the property and the amount of the mortgage. Okay. It has nothing to do with the pricing of the mortgage. That yield didn't exist when I started in the early 90s. The two sizing metrics that were used were loan to value and debt service coverage ratio. Loan to value is maybe simplest. It is the loan divided by the value of the property as determined by often an appraiser. Usually an appraiser. Debt service coverage ratio is the relationship between the net income at the property and the total debt service payments that will be paid at the beginning of the loan. And those two properties. Those two metrics were used almost exclusively during the period of time until the 1990s when interest rates started to fluctuate on a more frequent basis. So we've on our other presentations shown that treasury rates have been as high as 18% and as low as one and a half percent. There's always been fluctuation, but it started to become a quicker fluctuation in the 90s and that caused challenges when interest rates got to their all time lows. It seemed like in the mid-90s virtually every transaction worked on a debt service coverage basis. And if lenders had continued to size loans only based on debt service coverage, they would create challenges at maturity if interest rates were higher like the challenges that we're seeing now. And debt yield was created as a way to try to insulate the lending community and the sizing of loans from increases in interest rates, we're seeing now that that's only been modestly successful.

Very helpful. And also you can see, and I'm sure different lenders are focused, you know, I'm sure they're looking at all these metrics, but maybe some of these might be more of importance than others. But what I heard you say was that the loan to value is. And the value does not necessarily mean what you paid for the property. Right. So can we talk about loan to value versus loan to cost? And then when we're talking, when you go and finance a value add deal or a develop deal, you're actually talking about the loan to the total project cost. So maybe you could talk about each of those.

Yeah, I think in each of these topics that we raise, as you said, we can Go from survey course to graduate level, which is part of the fun of our business. Well, loan to value versus loan to cost. Much of the business that we do is our refinancing transactions where there is no new purchase price and there is no cost, original cost. Some of our clients have owned their. We're financing an asset now that our client built 44 years ago. So the original cost is really not relevant. So value is important to understand. Why does the lender care about value? The lender, senior mortgage lender taking the safest position in the capital stack, is also offering the to invest money at the lowest yield. Why are they willing to take the lowest yield? Because they have the safest position. Why do they have the safest position? They have the safest position because if there is a challenge for the borrower in paying the interest or repaying the debt, the lender can force the sale through a foreclosure process. And by limiting the amount that they lend to a less than 100% of value, the lender conceptually can withstand a decrease, significant decrease in market values and still be able to get all of its money back at maturity. A lender who makes a loan at 70% loan to value, if they're being realistic about the value at the time they make the loan, should be repaid in full, even if there's a massive decrease in the value of the property, say by 25. So that's the concept behind loan to value. The concept behind loan to cost is similar and it's pegging the metric cost to an objective value. The actual dollars spent to buy, build, fix a project in the period of time that the loan is covering. Now, where challenges occur is that loan to value is subjective. At any point in time, it is least subjective. I would argue at the end of a process where you market an asset for sale widely and anyone has the opportunity to come bid on the property and you work hard and well to drive that price to the highest it can be paid. That is a market driven value of that property at that point in time. At virtually any other time in a property cycle, value is much more subjective. And so appraisers play an important role in the industry and learn many. There's a lot of training that goes into learning to appraise properties and there are many different methodologies that are included in there to conceptually approximate the value that a property would sell for at a given point in time. So how deep, how deep do we want to go?

Very helpful. And we're trying to keep it high level. But we're also trying to make sure that everyone understands the terminology and the different approaches. And don't worry everybody next time, we don't want your brain to explode. So we're going to get more into financing, you say, James, you haven't even talked about interest rates yet and the indexes. So we're going to cover that in our next episode. And then we're going to dig even deeper into equity and JV structure in our last series. But again, since we're talking about not just key terms, but sizing today, talk about the sources and uses as our investors, our inspiring investors are thinking about, okay, I want to go buy this property and I want to improve it. They're thinking about how much capital this deal is going to require, what goes into those overall sources? Why don't you start by defining sources and uses, and then we can talk about how, again, you're trying to properly size up a deal to advise how much that sponsor can borrow and how much equity they're going to raise.

Okay, so I talked before that a mortgage lender was focused on lending at a less than 100% portion of the value in order to be able to withstand a decrease in market values over time. Sources and uses is what a lender uses to similarly lend an amount that's less than the total. And the total in a sources and uses is the total capital that's being invested in a project at the time. And so sources, sources and uses in a transaction equal the same. It's like a balance sheet. They equal the same number at the bottom. The sources side is the combination of the debt and the equity that's being invested in the transaction. And a third source that might exist in a property is cash flow over time, depending on the deal. The uses are what they sound like, how that money's going to be used. And so in a. Let's talk about a construction loan. In a construction loan, the uses are probably the most complicated, but can be narrowed down to the purchase costs. That's the acquisition price paid to the landowner, let's say, plus all the costs of closing that transaction. That's one section. And then the hard and soft costs needed to be spent in order to build the building and sell or rent the space within there. And a lender who's lending on a construction loan looks at what is the total amount of capital that it's going to take in order to turn this piece of land into a condominium building that's being sold out for more than what was lent and Then the costs in that construction loan, for example, are estimates. And sometimes they're estimates that are based solely early in a transaction on a developer's experience building other projects. Then it progresses to the point where the contractor goes out and gets bids for. They sign up an architect and they have a contract for how much they're going to pay the architect and they go out and bid the trades to determine what the hard costs are going to be, what are they going to pay to the plumbers and to the how much does concrete cost now and all that. So the sources represent everything that's needed in a transaction in a rehab of an existing property. Then the land cost is an acquisition cost of a building. The hard costs do not include the physical structure, but there's still hard costs to be spent turning the building from whatever it is now into whatever it's going to. So that's the basics of sources and uses.

Very helpful. And one question left. And just to let you all know why this is important, not just to understand this terminology, but how this works. This is not just for acquisition. So a lot of the questions I've been asking are what is the loan to cost? You're going in on acquisition. But one of the true benefits of being able to leverage the capital markets and you represent the who's who of New York families here, generational. So even if they're not as active today acquiring new properties, they are constantly improving, recapitalizing properties. So I just want to make sure everybody kind of understands what the opportunity is here. Because when we talk about loan to value, right? I mean, clearly the plan here is what you're buying the asset for today. The goal is to improve that asset, right? So it has a future higher value they can borrow against. And that is truly one of the benefits on how to capitalize on real estate. So maybe if you could just, you know, paint the picture for everyone to think about.

Well, and then a third component is simply stable assets that an owner is just continuing to maintain in order to generate a stable cash flow going forward to core properties. And so one of the biggest challenges, I said it's a challenge now to determine how the capital stack is going to play out in a transaction. Because in existing cash flowing assets, where the lending metrics are tied more to value than to cost, that question of valuation is one that obviously your team spends much of the day thinking about and driving. And there's been a substantial fluctuation in the cap rates that cash flowing properties are trading for. And there's chicken and Egg the debt. The increases in the treasury rates and in SOFR have caused higher borrowing rates which then affects the return on equity that buyers will receive if the income stays the same. Loan to value is very challenging. If we look back to pre Covid valuations, cap rates were fairly low then early Covid cap rates maybe went to their lowest in some regards because the treasury rate dropped so much. Cap rates rose significantly for others because of the concern of when would people get back to normal. And then we came out of COVID and into a new normal. One of the biggest challenges that we've seen in transactions from say spring summer of 22 when the Fed started increasing rates until let's say a month ago when seems to have become clear that the Fed is going to start cutting was in a development transaction for multifamily property or a rehab or value add for multifamily. Often the returns are very much driven at the end of the day by the exit cap rate. And we found that investors were unwilling to take risk around exit cap rates. And so getting back into this question of types of equity in an LP equity investment, the investor is sharing the risk with the sponsor proportionally and the sponsor may do everything right in improving a building and leasing it up. But if the exit cap rate that it can be sold for is higher than expected, the return on the deal might be very low. And so many investors pushed over the last 18 months. Many traditional LP investors said to sponsors, I may be willing to invest in this transaction, but only if I get my money back before you do, because I want to make, I need to, I'm telling my own investors at the next level that I'm going to generate a certain amount of returns and I want to be insulated from cap rates going too high. And so much of the shift from LP to preferred equity investing over the last year has been a result of that particular worry.

Great. Well, Scott, this was tremendous. Really appreciate your joining us today. A lot of information here and again, if you have not picked up the book yet, we have a whole chapter devoted to this. I know there's a lot to go over, but we're going to talk more in our next session about financing and then wrap it up with equity and JV structure. So thank you again for, for joining us.

Thank you for doing it and thank.

You everyone for joining. As always, you can go to james nelson.com where this is where I built this site for you and you can find not only this episode and show notes, but you can find other helpful videos, articles were featured on Forbes. And so again, this whole purpose is to help you gain the insider's edge to real estate investing. And if you like the show, share it with a friend, subscribe, give a rating that helps get the word out. So until next week, thank you again for joining SA.