The main differences between debt and equity risk and how it affects capital negotiations
We’ve all heard the term capital stack, which refers to the layering of different types of debt and equity to build the financing structure for a project. When designing the capital stack, developers and property owners often misunderstand that each of its components has its own characteristics and unrelated risk return profile. As a result, when structuring their overall financing solution, they can’t expect the positive or negative aspects of each type of capital will dilute or improve the positive or negative aspects of another type. Instead, a project and how it will be funded must be understood and evaluated while keeping the proper level of risk segregation of each building block in mind.
RISK VS. REWARD
There are multiple types of debt that can be included within a project’s capital stack – from senior to junior to mezzanine debt. The main differentiator among the flavors typically is the order in which the debt is paid back. Regardless of type, all debt is a promise to pay back the funds within a determined timeframe. For capital providers, therefore, the most important goal in every transaction is capital preservation. In other words, a debt lender’s primary motivation is to get that capital back along with a fixed amount of interest as profit. Developers evaluating their projects from a potential upside perspective often forget to take the lender’s motivation into account. This is a mistake, as it’s unreasonable to expect debt providers to be willing to take on the risk of any speculative component of a real estate transaction as would an owner or equity partner, because the return on the debt is not commensurate to that unknown risk.
Let’s look at an example of this debt provider risk-reward disconnect. If a hotel owner wants to reflag a Comfort Suites hotel to a Hampton Inn & Suites, for example, conventional wisdom suggests the overall revenue or RevPAR will be higher under the new brand. Debt providers, however, calculate revenue projections by evaluating the RevPAR of similar hotels to the Hampton Inn in the market’s competitive set and assuming 100% penetration.
Hoping for a larger loan to cost, a seasoned developer may ask the lender to consider a 120% RevPAR penetration to the market competitive set by arguing that the converted hotel will do 20% better than its peers in that area. This may be true, but while the developer may net a higher return after conversion and stabilization, he or she doesn’t turn around and share that upside with the lender. This is why the additional 20% RevPAR penetration is considered equity risk and not debt risk. Unlike equity investors, lenders aren’t willing to write a bigger check despite the expected future revenue bump, because they can only charge a certain defined rate such as SOFR + 400 basis points or 9% interest (example rate at the time of writing) on debt capital. Since a debt provider isn’t party to the equity’s returns, developers can’t expect lenders to be party to the equity’s risk.
Another nuanced example of this same concept is if a new factory is moving into a market and expectations are it will lead to more room nights for a nearby hotel, an increase in tenants for an area apartment building, or a new retail shopping center. Although those forecasted gains may actualize in the future, the additional expected growth or upside may not directly result in higher leverage loan today.
TAKING ADVANTAGE OF FUTURE UPSIDE
When developers and owners understand the role debt plays in the capital stack and the motivations behind how lenders make their decisions, they become better equipped to analyze real estate transactions and are perceived as more seasoned and sophisticated. Although debt providers can’t take part in an owner’s or developer’s lofty projections, in the event there’s an expected lucrative upside for the project, borrowers can use creative options such as mezzanine debt or preferred equity to build out their capital stacks. These types of instruments can take on an equity type of risk in exchange for higher return expectations – currently 12% to 15% for mezzanine capital and 13% to 18% for preferred equity. Final pricing will depend on the lender’s appetite for risk, the current market, and the supply of similar, competing assets in the area.
To ensure the most optimized capital stack, it’s important developers and owners work with an expert who structures a transaction not just from a loan placement perspective or brokering a deal standpoint, but who has the experience and knowledge to be able to convince the capital source of what is the right risk return profile of each layer of capital.
