Common equity loses first. Here's what we did about it.

Hi {{first_name | there}},

Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.

If you invest passively in commercial real estate, you probably pay attention to the projected return, property, market, and operator.

But here's another question:

If a real estate deal sells at a loss, who loses money first?

The answer depends on the deal structure and where your investment falls in the order of repayment.

Most commercial real estate acquisitions are funded with some combination of these:

1. Senior Debt

The senior lender has first claim on net operating income, refinance, and sale proceeds, but their upside is limited to interest and fees. Every deal we look at has some kind of senior debt.

Examples of senior lenders include Fannie Mae, Freddie Mac, life insurance companies, private debt funds, local/regional banks or credit unions, or CMBS.

2. Mezzanine Debt

Mezzanine debt, or mezz debt, has a contractual claim junior to senior debt but senior to equity. Because the mezzanine lender takes more risk than the senior lender, it generally requires a higher return. Its upside is still typically capped. We don't see many deals that have mezz debt.

3. Preferred Equity

Preferred equity is still equity, but it receives priority over common equity on cash flow from operations, refinance proceeds, and sale proceeds. Depending on the structure, the preferred investor may receive a current-pay return, an accruing return, or some combination of the two. Its return is generally capped.

We've made many preferred equity investments over the years.

4. Common Equity

Most passive real estate investors, especially LPs in syndications, invest in common equity. 

Common equity generally gets paid after everyone else. But it also gets the upside if the investment performs well. 

The trade-off is straightforward:

Common equity has the most upside potential, but it absorbs losses first. With the right operator and deal, it's not a bad place to be.

A few years ago, we created a structure we call JV Hybrid Equity. This is not an industry-standard term...we coined it ourselves.

In most ways, it's basically common equity. We do receive the same major-decision rights that we have in preferred equity investments.

Our JV Hybrid Equity and the common equity participate in available cash flow and refinance proceeds proportionately.

The important difference is when the property is sold.

After the debt and other obligations are paid, Wellings receives a return of its remaining JV Hybrid Equity capital first...before the common equity receives a return of its remaining capital.

Importantly, we don't get a larger share of the upside because of this protection. Once the common and JV Hybrid Equity have received their capital back, our JV Hybrid Equity participates in the upside alongside the common equity. 

The advantage is priority on return of capital in a downside, not extra upside.

If the property performs well and everyone gets their capital back, that downside priority is irrelevant.

But if there’s a loss at sale, it matters a lot.

Last year, we invested $8.75 million of JV Hybrid Equity in a five-property manufactured home community portfolio outside Raleigh, NC.

~$4 million of common equity is in first-loss position. For simplicity, assume neither equity tranche has received any return of capital during the hold.

Let's say the property is eventually sold at a loss and, after paying the debt and sale costs, $11 million remains for the equity investors. The waterfall would work like this:

But suppose only $6.5 million is left after paying the debt and sale costs. In that case, the common equity would lose 100% of its ~$4 million investment, and Wellings would also lose $2.25 million, or 25.7% of its $8.75 million investment. 

The JV Hybrid structure provides downside protection. It does not eliminate downside.

A fair question.

If we participate in the upside like common equity but get our capital back first in a downside sale, why would an operator agree to that?

There are a few reasons.

First, we can write $4 million to $15 million checks from a single source. Raising that amount from dozens of individual investors takes significant time and resources. There's also uncertainty. Speed and certainty matter to our operating partners.

Second, the operator earns a promote on our capital too, not just on the common equity they raise elsewhere. In almost all cases, we negotiate a better promote than what the common equity in the deal receives.

Third, there is no required monthly current pay to Wellings ahead of common equity.

Unlike preferred equity, JV Hybrid Equity doesn’t require a fixed monthly payment on top of debt service. Some operators avoid preferred equity for exactly that reason. 

Not every operator wants this structure. But since it's so close to common equity for the operator, it often makes sense for both sides. 

JV Hybrid Equity is not a free lunch.

It carries more risk than a traditional preferred equity position. Our cash flow depends directly on how the property performs, rather than receiving a contractual property-level current-pay return.

The common equity loss buffer is also finite. If the loss is large enough to exhaust it, our capital gets impaired too.

A favorable position in the waterfall cannot turn a bad property or operator into a good investment outcome.

We still have to get the property, operator, basis, debt, market, and business plan right.

Before investing in your next private real estate deal, I would ask two questions:

1. If the property sells at a loss, whose principal gets hit first? 

2. How much capital has to be lost before my principal starts getting impaired?

If you can't answer those questions, you probably don't fully understand where your money sits in the investment.

If you have feedback or there's a topic you'd like me to cover in a future newsletter, reply to this email. I read every response!

All the best,

Ben Kahle

Managing Partner | Wellings Capital