Understanding the Capital Stack

Understanding the CAPITAL STACK - What's Critical for You to Know

The order in which distributions are paid in a real estate syndication investment is called the capital stack, and your clarity on this concept is critical because it’s important for you to know where you fall in order of priority for returns as they get paid out. If you invest at a Class B level and Preferred, Class A investors receive distributions first, you want to know why, don’t you?

Understanding the waterfall effect in which returns are paid in a real estate syndication will also allow you to select real estate investment syndication deals in which the capital stack is favorable toward your investing goals. Your knowledge of the risk and priority at each tier is a vital piece of knowing why and when you’ll receive distributions. 

Here I’ll share what the capital stack is, why it’s essential, and how it impacts you.

 

To achieve your investing goals, it’s critical that you know the different ways an investment will pay out different classes of investors.

 

 The Waterfall

The way the capital stack works is called a waterfall. Imagine a list of everyone participating in the deal with the debt and equity partners categorized into groups – with those with the lowest returns and the highest risk at the top. When cashflow is available to pay out, it gets distributed like a waterfall, starting with those at the top and trickling down to those with higher returns and lower risk toward the bottom.

 

A waterfall structure is outlined in each deals’ PPM (Private Placement Memorandum) at the beginning of a deal. It explains who, how, and when each partner, whether general or limited, gets paid during the real estate syndication deal. 

 

Some investor classes receive only cashflow, while others participate in cashflow distributions and capital returns profits when the property is refinanced or sold. So, before you invest, you want to understand where your potential investment class is positioned in the waterfall structure and to know which payout types apply to you and how they contribute toward your financial goals. 

 

  • Are you solely focused on creating passive income in the form of monthly or quarterly cashflow? 
  • Are you mostly interested in appreciation on the property and “winning big” at the sale of the property?
  • Are you desiring a mix of both – a little support in the cashflow department plus some longer-term gains?

As we explore the types of waterfall structures and capital stack styles, keep in mind that any common equity or preferred equity partner is not in a position of debt. Also, cashflow distributions are always paid out to partners after the expenses, fees, and debt are paid on the property. 

The Impact

The capital stack affects investors in three main ways: 

 

  • Cash on cash
  • IRR (Internal Rate of Return / Yield)
  • Velocity

Cash on cash returns are the before-tax earnings an investor makes on their invested capital, also referred to as cashflow or distributions. If you’re in the preferred tier, you may have more significant cash on cash returns because preferred investors have a higher priority, thus get paid first within the pool of investors. 


IRR refers to the Internal Rate of Return and is a metric used to measure the deal’s profitability (cash and equity) over time. It’s a handy way of calculating your return on an investment while accounting for the time value of money, a concept that the value of money is different over time – a dollar today is worth more than a dollar in 10 years. 

 

Velocity is your ability to invest in more deals at a faster rate. As an example, when a deal gets refinanced, you may get some capital back if you’re participating in a capital returns position (not everyone gets their capital back – more on that in a minute). You can take that returned capital and invest in another project. This way, you’re effectively getting returns on two real estate syndication deals when maybe you only had enough for a single deal to begin with. 

 

Now consider that you would have a clear idea about each of these concepts and how each position in the waterfall or capital stack impacts each class. In that case, you’re able to make better investment decisions to support your personal financial goals and achieve them faster. 

The Capital Stack

As an investor, you always want to do your own research on the property, vet the sponsor team, and you definitely want to know who gets paid what, and when each payout is supposed to happen. It’s nice to know what to expect and be utterly comfortable upfront so there’s no confusion as to when you’re getting paid, right?

 

Well, the capital stack in a real estate syndication investment is where debt and equity partners are ranked in order based on an inverse relationship between risk and priority. The highest priority, lowest risk partners are toward the top of the capital stack, while the lower priority, higher-risk partners are toward the bottom. 

 

At the top, you’ll always have what we call Senior Debt. This includes mortgages and loans to finance the property. Just as you’d never miss a house payment, the senior debt is the highest priority, and they get paid first. Mortgage-type loans typically have a meager rate of return (2-4% for the past several years) in exchange for being top priority.  

Next, there are second-level, mezzanine-type loans like second mortgages and bridge loans. These are also debt positions and are ranked as a higher priority and lower risk than our limited and general partner investors. 

 

Continuing down the waterfall, you’ll see preferred equity (limited) partners come next. They are prioritized after debt payments but before the general partners. After the property mortgage, expenses, and fees are paid, preferred investors have “dibs” on distributable cashflow. There may be a higher investment required at this tier, and there are limited positions available at this level. Still, preferred investors often have a higher projected cashflow than other investors down the waterfall. 

 

Following the Preferred Equity Partners are the Common Equity (general) partners. This tier comes with the highest risk and the lowest priority. These investors are likely participating in capital returns and cashflow distributions but fall after the preferred level, typically with a split of earnings up to a certain percentage of cashflow. 

 

There are two main types of capital stacks – single and dual-tier. Just as you might imagine, the dual-stack is a little more complicated.

 

Single-Tier Stack

In a typical single-tier stack, Senior Debt is at the top, carrying the lowest risk and ranking highest in priority. A great example of this is a mortgage at an approximate ~70% loan-to-value ratio. 

 

Then you’ll see the Common Equity – Class A preferred return below the senior debt carrying a little higher risk and a slightly less priority. This would likely be the limited partnership level in a single stack, which might be earning a 7-8% preferred return with a 70/30 split beyond that. These limited partners (you) are likely participating in capital returns and would receive a portion of the profit after the sale too. 

 

The last level in a single-tier stack is Common Equity – Class B. These are likely the general investors who carry the most risk and are last on the priority list. They have no preferred return and only receive their 30% split of the 70/30 distributions if the property cashflows greater than the 7-8% preferred that the Class A investors are projected to receive. 

 

Dual-Tier Stack

The dual-tier stack is a little more complicated. Still, it’s becoming more popular because this waterfall structure can provide higher cashflow to class A investors with the tradeoff that Class A are not participating in capital returns. 

 

First up again is the Senior Debt and includes any mortgages or loans on the property. After this is where it gets fun!

 

Next, there’s a Preferred Equity – Class A level. This group receives projected cashflow at a preferred return only. This might be 9-10%, for example, with no payouts beyond that and no capital return. This is perfect for investors who are only looking for consistent cashflow distributions. One caveat might be that this Class A Preferred Equity status likely comes with a more considerable up-front investment with limited shares available. For example, less than 30% of the deals’ shares might be available for a minimum $100,000 capital investment.

 

After the Class A level, you have the Common Equity – Class B investment level, which may include preferred returns, splits beyond the preferred percentage, and capital returns participation. For example, maybe a $50,000 capital investment would earn a projected ~ 7% preferred return, 70% of the 70/30 split, and capital returns at the sale. 

 

Trickling down the waterfall, the last level would be the Common Equity – Class C. These investors carry the highest risk and the lowest returns because they receive cashflow after other tiers. An example of payout at this level might look like 30% of the 70/30 split and capital returns after the sale in exchange for a $50,000 investment.

 

Conclusion

As always, the capital stack and the waterfall schedule are outlined in the PPM (private placement memorandum) and are available to you as a potential investor before you commit to the deal. But, the PPM details might seem like gibberish if you aren’t clear on the capital stack, how it works, or where you fall in priority for distributions. 

 

Now that you have a solid explanation and a few examples, your confidence in reading any PPM and selecting a real estate syndication deal that is in alignment with your investing goals will skyrocket!

 

I’d love to share upcoming deals with you, but first we need to talk so I can hear about your investing goals and help you determine capital stacks that will be favorable for you. I have a couple deals in mind with different tier structures and would be happy to help direct you toward the one that will move you toward your goals more efficiently. 

SIgn up today at our Passive Income Investors Group to get the “inside scoop” on our past and upcoming deals. Once you apply to join the club, I’ll get on a call with you so we can see if we’re a good fit to invest alongside each other on any future real estate syndication deals! I can’t wait! I absolutely love helping investors like you create Passive Income…for life!

Cap Rates – What You Need to Know

What's Key to Know About Cap Rates ...and what's not!

Many investors get into real estate syndications after dabbling in the residential real estate space and realizing it can be a long, hard road to scale and that there’s a massive opportunity to earn better returns without being a landlord. But…the transition from residential to commercial real estate investments can bring about a number of new and more complicated terms and calculations to consider. 

 

As a passive investor in commercial real estate syndications, you just need to know how to calculate it for yourself and have clarity as to how the cap rate pertains to your financial and investment goals.

 


You may have heard about 7-caps from the cool kids, the fully-spelled-out capitalization rates from the proper, and cap rates from those who don’t have a minute to waste. These all mean the same thing though.

 

As you move deeper into passive investing and learn the amazing benefits of commercial real estate syndications, your confidence in evaluating slide decks and analyzers for each potential investment opportunity will grow. And in doing so, you’ll expand your vocabulary, become comfortable with terms, scrutinize past and present deals, and learn how uncomplicated investing passively in real estate can be. 

 

In the blink of an eye, “cap rate” will be part of your daily conversations, and not only will you know exactly what it means, you’ll know when and why it’s important and whether it’s good when cap rates compress!

 

It’s okay if cap rates are hard to understand or challenging to calculate. As a passive investor, you can inhale a deep calming breath because you won’t need to calculate or use them very often. Inhale…exhale…

 

In this post, you’ll learn what cap rates are, how they’re calculated, when you’ll want or need to use them, and what they reveal about an investment opportunity. You’ll want a certain level of comfort with cap rates and, by reading this article, you’ll learn how they apply to your investing goals and deal evaluations.

Cap Rates Defined

 

Cap rates, as they are so often referred to, are short for “capitalization rate”.  Quite simply the term quantifies and normalizes a property’s income earning power against the market value of that asset. Cap rates are used in commercial real estate to measure the expected rate of return generated by an investment property. 

 

No matter whether we’re talking stocks or real estate, it’s assumed that a higher cap rate equals a better ROI (return on investment), which would theoretically equal a better investment choice. However, there are some nuances as to how the cap rate is calculated, and cap rate discussions can get murky. 

 

As a passive investor in commercial real estate syndications, you just need to know how to calculate it for yourself and have clarity as to how the cap rate pertains to your financial and investment goals.

 

Commercial Real Estate Cap Rate Calculations Decoded

 

Anytime cap rates are being discussed, make sure you ask how they calculated the cap rate. You want to make sure you’re comparing apples to apples, and you’d be surprised at the number of various ways people calculate cap rates. 

 

Cap Rate = Net Operating Income / Property Market Value

 

Net operating income, or NOI for short, divided by the property’s market value is the most popular way to calculate the cap rate. Sounds simple. Right? Let’s take a look… 

 

A 7% Cap Rate Example And What It Means

 

Pretend that we’re looking at a value-add multifamily complex priced at $1 million that brought in $100,000 in gross income over the past year. Let’s also pretend that expenses for the year on this property were $30,000, giving us a net operating income (NOI) of $70,000. 

 

We take $70,000 (NOI) and divide that by the $1 million market value and arrive at 0.07.

 

This means the cap rate for this property is 7%, and if we were to buy this property for cash right now, we could expect to earn $70,000 in net income over the next year. 

 

So, in general, this is your projected return on investment (ROI). And although it shouldn’t be the only metric you review, it’s an indication of how profitable your investment may be. 

 

I love flipping these numbers into applicable life/length metrics to help me understand them more clearly. Check this out:

 

A 7% cap rate essentially means it would take about 14 years to recoup your $1 million in capital initially invested ($70k goes into $1M ~14.3x). To give you even more perspective, a 6% cap rate on that same $1 million investment would require about 16 1/2 years to recoup your investment, and an 8% cap rate would take about 12 1/2 years. 

 

See the trend there?  A higher cap rate on a similarly valued property yields a higher NOI which pays you back faster. 

 

What Kind Of Cap Rate Should You Look For?

 

If you’re all about cash flow, a higher cap rate may seem more attractive.

Higher cap rates mean you’re getting more income for lower initial investment, and you’ll recoup your capital invested within a tighter timeframe. 

 

A lower cap rate means your investment is higher, and the returns are lower. It will take more time to recoup your initial investment, but if you’re exploring more of a buy-and-hold strategy, it’s possible to come out better in the long term. 

 

So, what’s a “good” cap rate for commercial real estate investments, then?

 

There’s not actually a straight answer here. As much as I hate to be vague, it really depends.

 

What’s good in one market may not fly in another. There are variables to consider like potential market growth, other properties’ cap rates in that same market, the property value versus net operating income, if property expenses can be reduced as part of a value-add deal, your desired cash flow, and many more variables. 

 

We suggest evaluating several properties in your specific target market (or better yet…submarket) to get the best apples-to-apples comparison. 

How Should Commercial Real Estate Cap Rates Be Used?

 

Since the cap rate is only a single measurement taken at a single point in time, relying heavily on cap rates isn’t really a great strategy. (Side note – relying on any 1 metric heavily is not a great strategy!)

 

Some investors look exclusively for deals with 8% cap rates or higher, but considering cap rates are based on today’s market value and NOI and don’t consider leverage or time value of money, there are definitely other, more defining metrics that should be given attention alongside the cap rate.

Compare Properties Across Your Target Market Using Cap Rates

 

The best way to put a cap rate comparison to use is when looking at several properties in a particular target market. Let’s assume you’ve decided my home town of Fort Worth, Texas is your target market for a value-add apartment complex. Then, ideally, you could compare a few properties within that immediate market or sub-market.

 

If you see one with a 6.8% cap rate, another at 7%, and another at 7.3%, you know that all three are pretty comparable. You could confidently dive deeper into the 7% deal knowing you’re right on track with returns and purchase prices of other properties in that same area. 

 

On the other hand, if you discover a wide discrepancy between cap rates on similar properties in the same market, that could be a red flag. I’d recommend diving into the deals’ metrics deeper, find out how the cap rates were calculated on these properties, if there’s anything wrong with the property, or if the property is somehow being valued incorrectly. As with most metrics, it can also be tricky if there aren’t a lot of data points to see clear trends. 

 

Potential Risk Can Be Indicated By The Cap Rate

 

You can also use the average cap rate of a market to measure an asset class’s risk. Higher cap rate properties tend to be riskier and located in developing areas, while properties with lower cap rates are generally less risky and located in more stable regions. It’s not uncommon to see A-class luxury or new build properties with low cap rates (5-ish) and B & C class properties in the same market trading at higher rates (7-ish). Risk and reward.

 

And if you’ve ever heard about cap rates compressing, all that means is the cap rate is decreasing in response to higher property prices and lower rates of return. This is common in California, for example, where the demand is high, so people are willing to pay more to snag a property even if returns are a bit lower. And in major metro areas across the U.S. the trend is the same lately. 

Why Should Passive Investors Care About Cap Rates?

 

Now that you’ve seen how to calculate the cap rate, learned what a cap rate even is, seen a few examples, and have a firm grip on how you could use cap rates to compare properties within a target market, what about cap rates really matters to you as a passive investor?

 

Sorry to break it to you, but cap rate specifics aren’t going to change your life. 

 

There are many more important numbers and metrics that will make a bigger impact on your investment game! When it comes to vetting a potential investment property, you’ll want to pay more attention to the experience and integrity of the sponsor team, the overall market in which you’re investing, and that the distributions support your investing goals. 

 

Two aspects regarding cap rates will primarily matter to you:

1 – Is the cap rate comparable to other assets in the area?

 

You’ll know you’re working with a great sponsor team when you see they’ve already ensured the cap rate for the property in which you’re investing is in alignment with comparable properties in the same target market. Sure, it’s safest to double-check a few numbers, but with a solid, well-vetted sponsor group, that’s about all you need to do. 

2 – What’s the exit cap rate?

 

Wait! What? Right when you start to relax about this cap rate thing, I’m throwing in a twist.

 

It’s not a big deal, though, because with all you’ve learned about cap rates already, learning about the exit (or reversion) cap rate is going to be a piece of cake!

 

The exit cap is simply the projected cap rate at the asset sale, or disposition. This usually varies from the cap rate at the time of purchase. 

 

And here’s the most important detail out of this entire article – ready?

 

When considering a commercial real estate syndication opportunity, you want the exit cap rate to be a minimum of 0.5% higher than the cap rate at which you invest or buy the property. 

 

“Why”, you ask? Well before you invest, you want to see that the general partnership is assuming the market conditions at the sale will be less favorable than the current market. You want to invest in a property with conservative underwriting such that the property might sell for a lower price when compared to the net income, 3 – 5 years into the future.

 

As an example, if the current cap rate on your real estate investment opportunity is 7%, you want to make sure the exit cap (or reversion rate) is 7.5%. So, even after all renovations are made, efficiencies are increased, the occupancy rate is high, and rents are raised, you want the sponsors to expect a lower sales price compared to the higher net operating income (NOI).

 

No one knows what the market will look like in the future, so projecting that it will be a little softer at that time is much safer than not.

What Do Cap Rates Ultimately Mean for Passive Investors?

 

In general, cap rates are just 1 element of evaluating a commercial investment, but it’s a great foundational piece. 

 

Cap rate is just a single metric pulled based on the current value of the property. The rate may be different in 6 months or a year, and drastically different a few years from now. Knowing all the ins and outs of cap rates doesn’t help you project the potential of your investment or help you calculate the cash flow you may receive. 

 

But really all you need is a fundamental understanding of cap rates and to be aware of the reversion rate when exploring a potential real estate syndication investment opportunity. 

Want To Learn More?

 

If there’s anything I’ve learned in this life, it’s that there’s always more to learn. So if you’re ready for a deeper dive into metrics that DO matter and you’re interested in comparing deals alongside us, we’re here to show you the way.

Passive Real Estate Investing

 

Passive investing in commercial real estate syndications is a great way to generate monthly cash flow, grow your retirement funds, and harvest the benefits of long term appreciation on physical assets. 

 

If you’re interested in learning more about how you can invest in real estate alongside us without becoming (or remaining) a landlord, you’re invited to join our Passive Income Investor’s Group

 

Inside we share exclusive deals, helpful definitions and articles, debunk investing and real estate myths, and SO much more. We’d be thrilled to have you as part of the team and to get to share our members-only resources with you!