Want to buy a piece of real estate, but need some equity to get the deal done?
Banks today are less aggressive than they were 12 months ago. So when you are seeking financing to acquire a a piece of real estate, you may find that the equity required to complete the acquisition is more than you have. So as you set out to raise the money you need, your main concern may be that if your investor puts up the majority of the equity, you will end up ceding control to your investor.
So how do you structure your deal?
Consider giving your investor a preferred return. If you form a partnership to acquire the real estate, structure it so that the limited partner – your investor – gets a preferred return. Subject to what the investment objectives of your investor are, you have a lot of flexibility when it comes to structure. For example, if you require more cash flow to fund improvements or carrying costs until stabilized occupancy, you can structure the the partnership so that the preferred return accrues rather than paid in cash. Or, if you’ve structured a high preferred return to the investor, you can pay some of the dividend in cash and accrue the rest.
Keep more equity.
Structuring a preferred return for your limited partner means less dilution to you (meaning that you will give up less equity) for two primary reasons. First, is something called preference. Preference means that the limited partner will receive his money back before the general partner – they’re further up the pecking order when it comes to distributions. Preference is not just a concept that applies to the L.P./G.P. relationship; it also applies to debt financing. A senior bank loan has a preference over a mezzanine note. And, as a bank loan is cheaper than mezzanine, likewise, the limited partner’s capital will be cheaper than the general partner’s capital.
The second reason this structure should be less dilutive to you is due to the components of the return to the limited partner. The return to your limited partner has two components – dividends and equity kicker. The dividend is expressed as a percentage of the face amount (or principal) of the investment. You can make this dividend whatever you’d like – 8%, 12% or 18%. And, as mentioned above, the dividend can be structured as current pay or accrued. However, since money today is worth more than it is five years down the road, if you accrue the dividend, you will have to give up more equity to achieve the targeted return the investor is seeking. Note also that the dividend provides your limited partner with a preferred return, meaning that they get a return on their money before the general partner does.
The equity kicker is a claim to some percentage of the equity of the investment. The equity kicker is defined in the partnership agreement, or identified by virtue of the general partner’s carries interest. The equity kicker allows the limited partner to participate in the increased value of the real estate holding after receiving their preferred return.
So for example, say you determine that the return to the limited partner needs to be 25%. If your preferred return is 12%, then 13% of the return needs to come from the equity kicker. Based on your base-case projections and the structure of the transaction, the equity kicker may require 20% of the equity or it may require 60% of the equity. Each situation is different and requires that the deal get modeled to see how the returns behave.
So if you are seeking to raise capital, think through the preference issues of your limited partners and keep more of the equity for yourself.