RealtyShares understands that different investors have different risk appetites, and so offers several different product types with different associated risks and return objectives. For marketplace investors, it’s important to understand the kind of financing being provided – because different types of financing mean different levels of risk.
There are plenty of reasons why real estate companies may use “leverage” – other people’s money – to attempt to earn a higher return on their own investment. For marketplace investors who provide that financing, though, it’s important to understand the kind of financing being provided – because different types of financing mean different levels of risk. (article continues below)
Real estate professionals speak in terms of the “capital stack.” This refers to the different “layers” of money contributed for a project’s financing, and the varied rights that are attached with each such layer. Generally speaking, as you move “up” the capital stack from debt to equity, you enter zones of increasingly higher risk – but also potentially higher rewards.
With RealtyShares’ debt investments, investors essentially act like a bank, indirectly lending to active real estate companies that are (typically) financing a property for the short-term – while the project is being renovated or constructed.
The underlying loan typically has a 12-month term and is usually secured by a 1st-position mortgage or deed of trust (the security document depends on the state). Some kind of guaranty is usually obtained from the principal of the borrower – either a “bad-boy” guaranty backstopping events such as fraud or gross negligence or, in some instances, a full payment guaranty — so that the principal’s personal assets enhance the security of the loan. RealtyShares loans only to business-purpose borrowers (active real estate investors), not to borrowers of owner-occupied residences.
There are plenty of reasons why real estate companies may use “leverage” – other people’s money – to attempt to earn a higher return on their own investment.
RealtyShares investors do not, however, hold the mortgage directly. Rather, a RealtyShares subsidiary, RS Lending, Inc., extends the loan to the borrower, and then sells to investors its own debt securities (i.e. promissory notes from RS Lending) that mirror the payment terms of the underlying borrower loan. These notes are called “borrower payment dependent notes,” and the structure is similar to that used by LendingClub and most major real estate crowdfunding companies.
Although the structure removes investors from a direct claim upon the loan’s security (the mortgage) and introduces counterparty risk with RealtyShares, it eliminates the administrative and legal costs associated with setting up a separate entity for each investment. In any event, it would still be RealtyShares that would manage any foreclosure or related workout processes, so that the structure doesn’t involve any material change in how the loan and investor payments are actually administered.
RealtyShares has introduced several ‘bankruptcy-remote” features designed to limit the counter-party risk – and we just procured another significant round of financing. RealtyShares also continuously reviews the opportunity to engage a third-party servicer, the presence of which would also serve to diminish any processing disruptions.
Mezzanine Financing — Subordinate Debt
Mezzanine financing is an in-between space (junior to 1st-position debt, but senior to equity) that can be pretty interesting for both borrowers and financiers. However, conventional subordinated debt with a 2nd-position lien – “junior mortgages” – have become relatively rare. Ratings agencies now require that primary loans looking to be securitized in the commercial mortgage-backed securities (CMBS) markets not have a 2nd-lien mortgage on the property. Junior mortgages have thus been largely eliminated as a financing option.
Mezzanine Financing – Preferred Equity
Preferred equity is in many ways similar to mezzanine debt, where borrowers typically pledge as collateral all of their equity interests in the entities that control the underlying real property.
Preferred equity arose as a way to have an automatic, self-exercising structure with direct contractual rights contained in the entity’s operating agreement. Preferred equity also avoids the need of an inter-creditor agreement with the senior lender, and enjoys a better position in any bankruptcy scenario, since equity positions are generally not subject to “automatic stay” or other constraints imposed by bankruptcy law.
Like debt, preferred equity involves fixed terms (redemption dates, usually 2-3 years) and generally involves regular payments (typically monthly), and it is treated like debt for tax purposes.
While preferred equity investments do not have any foreclosure rights per se, they have specific contract remedies set forth in the entity’s operational documents in the event of a financial delinquency or a “change of control event.” In these events, the managing control of the investment entity would shift to the preferred equity investor, or the sponsor might be forced to sell the underlying property. These rights may vary, however; particularly where property loans are provided by government-sponsored agencies like Fannie Mae, any such rights may be quite limited.
Preferred equity return objectives are generally higher than with first-position debt; this is because these investments present increased risk. The higher risk is generally due to either (i) the presence of a 1st-position lender that has the lien on the property and who thus holds the primary security or (ii) the project has a significant construction component or other element involving more risk than an already cash-flowing property.
Equity investments put investors in an indirect ownership position so that they participate in the property’s excess cash flow as well as any appreciation realized upon its sale.
The investments are usually for longer periods (3-5 year targets), since the project typically involves extensive renovation or other “value-add” efforts by the sponsor. These investments typically can involve quarterly cash flow distributions and may have certain tax advantages.
For marketplace investors, it’s important to understand the kind of financing being provided – because different types of financing mean different levels of risk.
As a rule, there is no real “security” with equity investments, and (particularly with investments in pools of properties, or “funds”) the quality of the sponsor is important. The sponsor manages the project and controls nearly all relevant decisions. In a few situations, where RealtyShares provides a significant portion of the desired equity, we may have certain control rights or an ability to remove the sponsor for negligence; generally, however, this is either not the case or any such rights are shared with other equity investors.
Equity structures typically involve a “preferred return” (often 5-10%) that is payable to investors on a quarterly basis; any available cash flow beyond the preferred return is shared with the sponsor, with a common split being 75% to investors and 25% to the sponsor (though individual deals vary). Investors also participate in any appreciation or depreciation upon the sale of the property; this feature generally causes equity investments to feature the highest return objectives among the various product types.
However, equity is also the “first loss” position, and thus the riskiest among the product types; if the property’s value fails to appreciate or generate sufficient cash flows to cover the debt and preferred equity hurdle rates, the common equity investors get hit first and could experience a negative return.
Investors are aggregated into a special limited liability company (LLC) that RealtyShares manages; it is that LLC that makes the actual investment into the sponsor’s company formed to hold the property. This structure allows the sponsor to deal with only a single investor, and thus a single tax return and informational update.
Possible Tax Benefits
The pass-through nature of the sponsor’s company (usually an LLC or a limited partnership) together with that of the RealtyShares LLC allows investors to enjoy the tax benefits of direct real estate ownership; this is a significant difference between our “direct participation” structures and REITs, for example, which don’t feature all the benefits of a direct pass-through.
These tax benefits can include depreciation, mortgage interest, and other deductions that often offset (sometimes entirely) the actual distributable cash — so that investors may receive distributions throughout the year and yet may have little or no taxable income. Much or all of this tax advantage is subject to “recapture” at a later date, however, at the time that the property is sold; nevertheless, the tax deferral benefit of real estate equity investments can be a significant one.
Shared Risk Factors
All of the RealtyShares products share certain significant risk factors: all of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC.
The required disclosures associated with the offerings are therefore less detailed than an investor would typically expect from a registered offering, and ongoing disclosure requirements are negligible. The offerings are also illiquid, with no preset liquidity terms. Whether investing in debt, preferred equity, or common equity, an investor should have no expectation of liquidity before the maturity date or final liquidation of the real estate project. Finally, because these offerings are only available to accredited investors, the liquidity in any circumstance will be more limited than for registered, publicly-traded securities.
RealtyShares understands that different investors have different risk appetites. Some may like debt investments that relate to a loan with a first-lien mortgage; others may be interested in the higher return objectives associated with a preferred equity position, in spite of the increased risk. Still others may want to invest in an equity position’s potential upside, and take advantage of the tax benefits associated with real estate ownership, even though equity is in a “first loss” position.
Each of these product types has different associated risks and return objectives. Investors should consider their own risk / return appetites in determining which investment types – or combinations thereof — may work best for their particular portfolio.
Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.