Much like Maslow’s hierarchy of needs, which outlines the order in which mankind’s needs are met, there is a hierarchy in a private equity capital structure that determines the order of distributions.
It’s important to understand that a commercial real estate property is, in essence, an operating company that is backed by a physical asset. It has revenues, customers (also known as tenants), expenses, net income and net cash flow (hopefully) that may be distributed to its owners. Two equations, Net Operating Income (NOI) and Net Cash Flow, illustrate this point:
- NOI = Total Revenues less Total Operating Expenses
- Net Cash Flow = NOI less Debt Service minus Operating Reserves and Capital Expenditures
The higher you go in the capital stack, the less likely it is for that layer to receive distributions, and the probability of receiving those distributions at the higher positions in the capital stack can vary dramatically. A capital stack has a priority of payment as follows:
Breaking down the capital stack
It’s important to remember that every layer is dependent upon positive NOI. If an asset becomes distressed you can find scenarios where NOI becomes negative. But assuming that NOI is positive, as is usually the case, here is how each layer of the capital stack receives distributions:
- Senior Debt: The most senior of all forms of capital in the stack, senior debt must typically be paid monthly or else the borrower goes into what is referred to as “default.” Because it is most senior and repaid first, senior debt receives the lowest returns relative to the other, subordinate layers of the stack. For investors that want the greatest certainty of income and are willing to forego all potential upside in a deal to get it, this is the safest spot to invest. Because it is debt, this means its interest must be paid periodically (typically monthly) and its principal must be repaid by the time of maturity. If not, then senior debt holders can assert rights to seize control of the asset and/or seek recourse from the borrower. Annual targeted returns to senior debt vary but can typically range from roughly 3.5% to 8% per annum. Generally speaking, the higher the interest rate the higher the leverage as a percentage of the value of the property and/or the greater the risk of default.
- Mezzanine Debt: While still debt (meaning it has an obligation of the borrower to pay it), this form of debt is subordinate to senior debt. Its interest is paid only after the senior debt receives its interest payments. However, provided that an asset produces net cash flow over and above what is due to the senior debt, then mezzanine debt interest must be paid prior to any distributions to all forms of equity. As you can imagine, this layer has more risk than senior debt and, as a result, it is typically compensated commensurately. Targeted returns for mezzanine debt also vary depending upon the level of leverage and risk involved in the deal but typically range from 8% to 13% per annum. It’s important to note that sometimes mezzanine debt is paid current from operating cash flow and, in other instances, it has only a portion of its total interest due paid current with the balance accruing and paid at a later date.
- Preferred Equity: The biggest difference between preferred equity and mezzanine debt is that preferred equity is not “debt.” This means that this type of capital takes on greater risk of non-repayment since there is no longer an obligation of a borrower to repay it. Preferred equity stands in priority to common equity. This means that, once debt service is paid (whether that is only senior debt or a combination of senior and mezzanine debt) preferred equity receives the share of distributions due to it before any distributions are paid to common equity holders. You may also see preferred equity substituted for mezzanine debt in a capital stack since it is easier to gain approval from a senior lender. When an asset has strong NOI and, usually, a high debt service coverage ratio, preferred equity can present a great way to receive regular distributions in exchange for only giving some upside away to common equity holders. Because preferred equity lacks the repayment obligation of debt, returns are typically higher than mezzanine debt—but it is often placed at a similar position in the capital stack. Targeted returns also vary for preferred equity but can range from 9% to as high as 18% per annum depending on the scenario.
- Common Equity: The top layer of the capital stack, distributions from common equity occur only after 1) debt service (both senior and subordinate) is paid 2) preferred returns to preferred equity (if it is used) are paid and 3) reserves are funded for capital expenses and all partnership items (e.g. annual tax preparation). Provided that excess net cash flow is present after all of the above are satisfied, common equity holders may receive distributions. The key thing to remember for common equity holders is, typically speaking, there is no obligation by the manager to pay distributions to common equity holders at any time.
Distributions at the common equity layer of the capital stack are made at the sole discretion of the sponsor and this is the only layer where this situation is the case. Even if there is adequate cash flow to pay distributions, there may be a good reason to reserve them and not pay them, such as funding unbudgeted tenant improvements to land a new big lease at a property. This makes distributions at the common equity level far more unreliable than any other layer in the capital stack. Given the non-obligatory nature and relative unreliability of common equity distributions, it’s not surprising that you tend to see tremendous variability in an operator’s ability and willingness to pay them. Certain operators may pay distributions almost as reliably as mezzanine debt, while others hardly pay them at all. Therefore, for any investor that views the prospect of distributions as an attractive part of a common equity investment, it’s important for that investor to both study that operator’s track record of actually paying distributions, as well as listen closely to the operator’s expectations, strategy and philosophy regarding paying distributions in the proposed investment. As can be expected, targeted returns vary the most at the common equity level and can range from as low as 8% to as high as over 30% per annum depending on the leverage and overall risk to the common equity holders.
When a sponsor’s pro forma shows net cash flow at the common equity level of the capital stack, it’s a common and understandable practice for investors to view the probability of receiving targeted distributions from a private equity real estate investment at one layer in the capital stack as relatively consistent with any other layer in the capital stack. When an asset performs exceptionally well this might be the case, but, under most circumstances, it is far from the case. As described above, the range of targeted annual returns from as low as 3.5% for senior debt to high as 30% for common equity factor in numerous assumptions, and the probability of receiving distributions is one of them.
Which layer is right for you?
At the extremes of the capital stack, it’s relatively easy to understand that a 3.5% senior debt return is far different than a 30% common equity return. But, what about a 13% targeted preferred equity return versus an 18% targeted common equity return? In this situation, paying close attention to the hierarchy of distributions can help lead an investor to the right investment decision. For the investor who prioritizes cash flow distributions over the possibility of a 20%+ annual return, then the preferred equity investment is superior. Conversely, for the investor who places less value on current cash flow and, instead, is seeking the opportunity to earn greater upside that may exceed 20% annually, then the common equity investment is the superior choice. And, like anything in life, you can’t have it all. This is why each layer of the capital stack has different strengths and weakness. The appropriate choice boils down to your objectives and investment criteria. Just don’t fool yourself into the notion that it’s possible to receive the certainty of cash flow of senior debt along with the targeted returns of common equity.