Sponsor Equity: This is the cash investment contributed by owners of a project.

Preferred Equity: Preferred equity is similar in structure to a mezzanine loan; however, many of the complexities involving mezzanine debt are avoided. Inter-creditor agreements with senior lenders are not required and, because this investment involves equity and not debt, prohibitions in the senior loan documents against secondary debt become irrelevant.

The returns and general investment time horizons required by preferred equity investors fall into the same range as that of mezzanine debt. These investments are generally structured so that after the payment of debt service the investor receives a coupon return of 8 % to10 %. From the remaining cash flow, the sponsor is paid the same coupon return as the investor before distributing the remainder between the parties based on a predetermined formula. Unlike traditional equity, which shares the upside of a transaction with no ceiling, preferred equity investments enable a sponsor to determine at inception what will be necessary to pay off a preferred equity partner in the future.

This structure is attractive to a sponsor who can contribute capital for 10% or more of a project cost and has an operating plan to increase net operating income over a three-to-five year period.

Institutional Joint Venture Equity: Institutional investors have a strong appetite for joint ventures with experienced owner-operators or developers. Most importantly, investors seek a strong operator with a track record of success in a particular market. Investors seek partners who can create value in a way they can’t on their own. Creation of value can come in many ways, including the identification of off-market transactions that are purchased at attractive prices, rehabilitation of an asset in need of work, more effective management of a property or ground up development of an asset.

Yield expectations among institutional equity investors vary based on several factors, including transaction risk, desired hold period, the amount of leverage, and the amount of co-investment by the sponsor. Generally, investors seek five-year internal rates of return between 15% and 18% on an un-leveraged basis. On a leveraged basis, returns generally range between 18% and 22%. In many instances, institutional equity partners seek to limit overall property leverage to between 50% and 60%, thus lowering the internal rate of return to the sponsor.

Institutional joint venture equity transactions generally are structured so that the institutional investor contributes between 80 percent and 90 percent of the required equity, with the sponsor investing the remainder. These joint ventures usually include buy/sell agreements that allow a sponsor to buy out the partner within a specified time period. Investor’s generally have approval rights over major decisions including financings, sales and annual budgets.

The capital stack is the total mix of capital invested in a project, including pure debt, hybrid debt, and equity. The higher the investment appears in the stack, the greater the risk for that investment. The lower the placement, the less the risk. As a consequence, higher stack positions expect greater returns on the capital invested because of the higher risk involved. The typical capital stack is arranged as follows:
1. Sponsor Equity
2. Preferred Equity
3. Mezzanine Debt
4. Senior Debt

Andy Bogdanoff is the Founder and Chairman of Remington Financial Group. Mr. Bogdanoff is an expert in commercial real estate and equity capital transactions with over 35 years experience.