#157 - Who Gets Paid First? How Real Estate Deals Are Actually Structured

[00:00:00] Hello, welcome back to Passive Income Pilots everyone, Tait Duryea and Ryan Gibson. How you doing Ryan? I'm doing great. You know, it's been a great start to the summer. Done some flying in the plane. I think last time we talked I was heading out to the ranch and You were? Yeah, and we're actually, we're gonna have the Jim Richmond Foundation on the podcast coming up. So if you're a backcountry pilot and you want to learn how that all works and the mechanics behind that, they're actually going to come on the show here.

[00:00:26] But anyway, I had a great time flew down to the ranch and did some backcountry flying and did some fishing with family. So Amazing. I'm going to be back. Yeah, that's fantastic. Yeah, we we've been kind of had our heads down so far this year. I'm excited to To get off site in a little while here and we're headed over Europe. We're doing a half marathon and in Chamonix in a couple weeks and Nice. Super excited for that, but I do the I do the Ragnar relay every summer. That's right. I got to come out there and do that with you. Yeah, July

[00:00:55] I think it's 10th and 11th in the Pacific Northwest Passage. Got a team this year And usually we take second or third place. We're gonna win this year though. I'm I'm confident in that so got my running down Hold you to that. That's right Well, speaking of winning, right? I think you know, we had a really good chat catch up before the show real estate deals are structured like a million different ways I think a lot of people don't realize that you can actually be participatory in more than just Being a partner in real estate or actually owning the real estate

[00:01:25] You can benefit from debt pref equity common equity different structures And I think investors don't in pilots sometimes don't really understand All the ways in which you can get paid in real estate, which I think is really cool But I think more importantly than that Is when you invest In a a real estate deal You kind of got to look up at the capital stack and say what is the order in which i'm actually going to get paid? Exactly because That is how I right size the risk. So I think that's we're going to get into today

[00:01:54] Tate what are your thoughts on this? Yeah, today we're going to unpack the capital stack and that's sort of a technical term a jargon term that we use in in real estate To look at the layer cake Of debt and equity that all comes together to take down a deal You can think of this as when you go and buy a house typically you don't buy it 100 cash, right? You get a mortgage Sometimes you might do an 80 10 10 where you do a 80 percent senior loan You close simultaneously Uh well on a heloc for 10 percent

[00:02:23] At closing and then you put 10 of your own cash down That is a capital stack and we're going to go into How these capital stacks work when you're buying commercial real estate How you can participate in each one of those segments and who gets paid first in all of that and the different risk profiles Participating in each one of those. Absolutely. Well that let's get into it. Let's get to the show Welcome to passive income pilots where pilots upgrade their money

[00:02:52] This is the definitive source for personal finance and investment tactics for aviators We interview world-renowned experts and share these lessons with the flying community So if you're ready for practical knowledge and insights Let's roll. All right, ryan. So we're talking about the capital stack today. We're talking about Common equity pref equity or preferred equity Uh, the senior note which is usually the largest capital partner in a deal is going to be the bank

[00:03:20] Uh, and then some different debt structures mes debt bridge debt things like that that you can bring into a deal And there's all these levers that you can pull and those levers can either increase or decrease risk on a project And we're going to talk about how you as an investor can participate in each one of those categories So ryan, where do you want to start here? Do you want to start bottom up or top down? Here's the first thing i'll ask is

[00:03:45] When someone says you're at the top of the capital stack or i'm at the bottom of the capital stack, what does that mean? Well, let me just start with a little bit of a framing of this, right? So I I think One of the most important things when I look at a deal In real estate some somebody always like tate you probably get asked this like 100 times a day Like people ask me this they're like, how do you evaluate doing a deal? Right and how do you go about like unpacking a deal and The number one thing that can go wrong in real estate

[00:04:13] The number one thing that can go wrong in commercial real estate real estate, whatever you're doing Is the debt that is what screws everything up, right? So if you have a piece of real estate and you own it and there's no debt on it Chances are unless it's some something catastrophic Chances are it's going to be fine, right? So then so it's kind of like I if I don't fly my airplane And I never take off i'll never have any risk, right? But then it's like what's the point of the airplane?

[00:04:40] So so then when you layer on a lot of debt like when you put on like 90 95 percent Debt that's when your risk starts to pile up But I think what we're going to talk about today and and to answer your question The being at the top of the capital stack or being being the most senior person who's going to get paid first lowers your risk, right? So if you're a first position lien holder on a property, which means that You're a bank traditionally or

[00:05:09] Maybe you're partnering with somebody and there's no debt and you're acting as the first position Basically, that means that you hold a promissory note. You have A deed of trust recorded against the property like you are in the front Right, so so even if the property is like highly highly levered and you're the first one getting paid That might imply that you know, you maybe carry the least amount of risk And this is why you get paid the least right?

[00:05:38] Right, so typically if you're a bank right now like you can go out and get a five or six percent loan If you're in the first position, you're getting paid first So you're going to take the lowest risk and you're going to have the lowest reward And so whatever comes after that is starting to take more risk on And should be compensated for the risk that they're taking, right? So when you think about a deal, you know You look at a deal and you're like, okay, this deal has no debt on it

[00:06:05] That deal has a less amount of risk than a deal that has a lot of debt on it and then when you when you're Investing in that deal And we're going to get into this today. You can be in any part of that deal You could be the senior lender so you could be at the very top of the capital stack Right, or you could be a mezz lender, which is usually like a debt funder like a second note Or something like that then you could be preferred equity

[00:06:30] And then you could be common equity. So if you're like if there's a lot of layers that got to get paid before you get paid You might be, uh, you know kind of lower in the stack so To answer your question more directly tate if you're The top of the capital stack that means you theoretically Have the least amount of risk And then it usually means you have the least amount of reward which means you you just make a simple interest or something like that Right So excellent explanation. Thank you for that I want to back up to your

[00:06:58] Scenario of buying real estate 100 cash and you know A lot of pilots out there are You know racing to pay off their their homes, which I get I get but You know the reason they're doing that Is because to them it implies that there's less risk which I'm not going to fight people on that You know if you have if you own a home and it's free and clear fantastic good for you and and we can get into the merits of

[00:07:25] You know borrowing against that asset and using those proceeds to invest in other assets to grow your wealth but in terms of purely talking about risk Buying real estate 100 cash your risk profile is exceptionally low. Let's rewind back to 2007 And let's put our shoe ourself in the shoes of an investor who was buying rental property Right before the market crashed in 2008 and they bought at the peak of the market

[00:07:52] And you paid 100 cash for a property Say it was a million bucks And the value of that property craters to 750 or 700 000 Do you really care? I mean your property taxes are probably what? I don't know 500 bucks a month You you're probably renting that property for five thousand dollars a month

[00:08:18] So you're making a clip on on that and you're going okay Well, the value came down, but i'm not really stressed because I don't have a debt service payment to make It's pure cash flow and this is why dave ramsey You know God bless him You know promotes this is because now you're pure cash flow You don't have that that heavy debt service load to pay And so those people that bought 100 cash in 07 Sure Mistimed the market a little bit, but do they really care?

[00:08:46] The value of the asset came down not really it'll recover its cash flowing in the meantime Compare that to somebody who levered up that property 90 they put 10 down so they put a hundred thousand dollars down It's worth a million the bank came in with 900. That's the capital stack, right? So you've got a hundred thousand in basically what we would call common equity in a commercial real estate deal And you've got nine hundred thousand dollars worth of senior debt And the property value collapses to that same seven hundred thousand dollar level

[00:09:16] You are now what we would call underwater And you're having to pay a monthly mortgage payment now on a property that's worth less than the debt that's on it So very bad situation where you owe the bank more than the property is worth And that's an extreme example of how you can look through uh the lens of of risk And it cuts both ways if the property value goes up

[00:09:42] Then you're you as a a common equity investor as the person who owns it and puts the down payment on it You own all that upside the bank doesn't take a cut of the property Uh, the the increase in equity the increase in value if that property goes up in value And that's why it's called leverage Because you're amplifying your returns But it cuts both ways on the downside. So ryan i'll turn it back to you No, I love this because when you think about

[00:10:11] High leverage and risk, you know part of it was you know the value going down in your underwater and values That mean might mean the bank calls your note or that might mean you can't service the debt payment And you threw out a bunch of terms and I really don't want to leave the pilots behind here on on terms that I had no idea what these meant Before I got into this stuff, right? Common equity That sounds so Sophisticated, right? Like it's a financial term all that is is your down payment Right, so if you buy a house

[00:10:39] You go to a company to get your loan You have a loan and you have a down payment the down payment is common equity, right? So like when you're thinking about investing in real estate or syndication or you know, whatever You're talking about the common equity is sort of the down payment And so you are an owner you are a partner in that LLC or that real estate right as a common equity holder Yes, you are you are sharing in all of the upside and downside, right? You're sharing and

[00:11:09] The deal going completely wrong and losing all your money and you have no recourse, right? Like you you can't File a lien or anything like that. You're you're done. You're done, right? Right And this is what happened back in you know seven. This is why a lot of people just filed bankruptcy, right? They just walked away They're like i'm just gonna stop paying my note. Yeah, because They just gave the keys to the bank. They're like you take it. Yeah, i'm out And you mentioned senior debt and I just want to make sure that the listeners understand that so senior debt is effectively the bank

[00:11:38] Right, so if you buy a house you put down a down payment, that's your common equity You go get a mortgage. That's your senior debt. That's like the simplest capital stack In fact The capital stacks that I do for my real estate deals are our simple capital stack we have common equity and we have um senior debt There's usually not anything else that has any sort of claim against the property I think the next phase of this where it starts to get confusing and common equity is definitely the term is

[00:12:08] you you start having terms like Senior debt and then you have mezzanine debt, right? And mezzanine debt can come in different forms. It could be like a second position loan Um, so they're second in line to the first position And then you might have something called preferred equity, which is again It comes with terms and conditions That aren't necessarily like a lender, but you that person could be

[00:12:36] Obed money based on a very stringent thing with limited upside and then you have common equity and I think I think what's really important and and sorry to go on a tangent about this, but If you're a common equity investor, the first thing I should ask is what are the layers in the capital stack? What other debts or encumbrances are going to be on this property who else is ahead of me and getting paid? Right, so I think this is the big takeaway is like, okay

[00:13:04] I'm a common equity holder. This looks like a great deal. It pays, you know, it's projecting a 20 return or whatever it is annually And you go, okay, i'm making a 20 return But there's preferred equity ahead of me, right? There's a mezzanine lender ahead of the pref equity And there's a senior debt holder and they've leveraged 90% So the chances of me actually making 20% after all those layers are passed through Is like zero

[00:13:30] Right now, but I will say if it's levered up like that if it if it goes really well You stand to make a lot of money. Yep, because it's so leveraged exactly and I think great conversation in the other direction Is right if a property isn't that leveraged and there's not a lot of layers Then the risk is somewhat lower right comparable deal if you're comparing deal a to deal a and one has all those layers And it projects a 20 something percent return

[00:13:57] And then the other deal you're same deal same underlying asset, but it has just common equity senior debt And a lot and a lot less leverage and like you should expect that return to go lower Like five to seven percent annually lower because you're just looking at this and you're going well This doesn't carry as much risk as all these other layers, right? Right I want to back up real quick and and pose the question, you know If buying real estate 100 cash is so safe. Why doesn't everybody do it?

[00:14:26] Why don't you just buy your your deals with 100 cash ryan and then you know, you you wouldn't have to Have all this risk And you the the answer is if you're going to buy a million dollar house You probably aren't going to wait until you have a million dollars of cash in the bank to do it Similarly, you know a house might not even be the best Analogy in this situation Let's say that you start a business and that business is hauling

[00:14:55] Oranges from the orchard to the supermarket And in order to get the oranges from the orchard to the supermarket you need a truck Well, would it not make sense to go and get a loan for that truck so that you can generate returns? To pay off the debt That is what we would call good debt Because that is productive debt It is buying an asset that is generating revenue for you. It pays for itself

[00:15:22] You wouldn't want to sit around and wait until you had 70 grand in your pocket to go and buy that truck So then you could make the revenue that doesn't make sense. This is the whole premise of debt is lending money borrowing money So that you can acquire an asset that generates a return So if you now shift back to let's say a self-storage unit We're going to borrow money in order to lever up that deal First to magnify the returns because if we're to buy it 100 cash, you know

[00:15:51] You're going from a million dollar asset to a 1.2 million dollar asset You're going to make 20% you lever it up by 50% meaning you take $500,000 Of down payment and 50 $500,000 worth of debt Your returns are magnified You're you're still making 200 grand or 20 you know 20 percent of of asset value increase But it's on 500 rather than on a million. You're you're lowering the denominator in that equation

[00:16:20] Hopefully this is isn't too rambling, but can I can I give it short cut it please Please please So there's a there's a term in investing called return on invested capital When you have leverage your return on invested capital goes up When you don't have leverage your return on invested capital goes down That's it. That's it. So if you're like why is there debt? So the equity can make more money That's it. Yeah, and and if you have um, you know, and and I you know, I get this question all the time with from investors are like what

[00:16:49] Like why don't yeah, why don't you just put all you know, do this all cash? It's like well If I did this all cash then your return would go from like a 15% projected down to like a seven Right And so because you're a return on investor capital you have more miles to feed as equity holders If you put it and don't even think about number of investors think about dollars, right? If you take more dollars and put it into a deal Then all those dollars are going to make less return unless you find a friend Friendly dollars that come in at a at an inch at a fixed interest rate. That's lower

[00:17:19] Right and that they take up some of the space at a lower assumed rate with no upside Right, so call it a six percent loan Your return on invested capital is going to go up And so I think that's why it's interesting like commercial real estate right now like where where it's at is you know, it's hard to Have a good roic right now because interest rates are really high Right or higher than they've been And the price you pay for real estate is still a little bit on the high side So that's good. One thing I wanted to say though is like

[00:17:48] One way to increase your return on invested capital and that's a term roic The one way to actually make that more efficient Is to find the most efficient capital structure, right? So right if you go to a traditional bank They're going to give you a loan And the loan might be six or seven percent whatever it might be And and then you're going to go to an equity a common equity holder and you might say hey, i'm going to give you This much money if you invest in my project

[00:18:15] But the reality is is you know, if you have preferred equity coming in The preferred equity is going to have a lower overall return potential than the common equity So now you've added a layer into the capital stack that then makes it more lucrative for the common equity to make money And it also it limits their upside somewhat still still great returns It might be like a five percent current pay and a six percent kicker at the end or something like that

[00:18:43] But it but it's going to have that it's going to give that potency to make your roic go up Yes, and just so that you can visualize this I want to make sure everybody's following along here Preferred equity is going to sit Sandwiched in between the senior debt and the common equity So the common equity would be at the bottom of the capital stack. They're going to have the largest Upside potential because they're pure owners in the deal. They're the down payment They are they're participating in every bit of the upside of that project

[00:19:13] The senior debt is getting a fixed rate of return, but they are not Participating at all In the performance of that project. They want their interest payment and they want their money back That's it The pref equity piece can come in and it can hit sit ahead of the common equity In a preferred payment position meaning they have to get paid first But just like you said it's going to be at a lower

[00:19:41] Rate of return than what the common equity investors have it might be like you said, you know some some sort of current pay Maybe they're receiving five to seven percent cash flow and then a kicker at the end But they get paid first. So if the deal doesn't perform as well, they're in a much safer position Yeah, I think there's a lot of benefits that preferred equity and I and I think there's some things that you might want to distress test on a deal so You know when you're thinking about pref equity and being an investor, let's talk

[00:20:09] Let's talk about you being an investor like you're deciding to actually do a pref equity deal My first question would be what is the overall senior debt or what what's the debt ahead of mine, right? Right because you really have to size up, you know the current pay Means like if i'm a pref equity investor, let's just make something up current pay is they're offering six percent as a preferred equity Holder that might mean if they put in a hundred thousand dollars you're expecting to

[00:20:35] Make six percent, right? You're just making six thousand dollars on your hundred k investment and Your future upside could be when the property sells you could make another six percent. Let's just say Um, and that would have to be paid before the common equity. So before the the equity that's behind you And that's great. But I you know in this market. I There's been a lot of pref equity that has been offered It's been a um sort of a tool to sort of come in and sort of save a property that's

[00:21:05] Potentially under like drowning, right? Yeah, and capital So I would make sure that the senior debt I would check this i'd pop the hood on the senior debt and say How much debt is ahead of me and what is the leverage to the actual value of the asset? And then what is the ability to actually like what is the upside potential, right? Because you still have to have upside potential in order to you know, make that six percent at the end or whatever the terms are

[00:21:29] So, okay, you're going a little deep here. So I want to make sure that everybody's everybody's tracking what ryan's talking about is let's say a project It's worth 10 million dollars And The original capital stack Was just common And senior debt and let's say it was a 70 30 Uh, well, that's I should I should say it's 70 senior debt and 30 common equity Not overly leveraged

[00:21:57] That's a good deal, right? But you know Because the real estate market took a heck of a beating after interest rates rose in 2022 There has been an across the board Reduction in commercial real estate values over the past three to four years. Do you agree with that? Absolutely. Yeah So that 10 million dollar asset might now only be worth eight and

[00:22:23] The the cost of servicing the senior debt may have increased dramatically And so the property that was originally cash flowing nicely like like your rental properties cash flowing You can imagine if your your mortgage payment went from three thousand a month to six thousand a month You'd be hurting, right? And that's exactly what happened to this these a lot of these projects is there the cost of servicing that senior debt went up Dramatically overnight. So all of a sudden you have a property that's negatively cash flowing That is worth

[00:22:54] Significantly less than what you paid for it and You know Just like when you're flying an airplane and Thrust and drag need to be in equilibrium And in order to stay in level flight If your Drag dramatically increases cargo door pops open the parachute goes out That's that's like what you can imagine Uh, when you have this increasing cost of debt Now your air speed is bleeding off and what do you have to do in order to not stall? You got to pitch down

[00:23:22] You got to start eating into cash reserves. You got to pay the bank bank has to be paid Otherwise, they're going to take back that that asset that's now worth Eight million remember the bank Loan is at seven So the bank would be thrilled If you stopped paying because they're going to take back an asset that's worth a million dollars more than what you owe them So you do not want to let the bank take that back. You want to keep feeding the beast You want to keep paying that mortgage. However, the asset itself is negatively cash flowing

[00:23:51] So what ryan is saying is that a lot of times in recent history we've seen Uh a sponsor on that deal say hey, we need to bring in additional capital into this deal And they'll do that through a pref equity offering and so they'll They'll split the capital stack between the common and the senior debt And they'll wedge in let's say a million dollars worth of pref equity and they'll say listen common equity people Sorry

[00:24:18] But if we don't do this the asset's going to go back to the bank. You're going to lose all your money So we're going to bring in a million dollars worth of this new capital Sandwiched in between the senior debt and you They're going to get paid back first Maybe a fixed rate of return or some sort of a A hybrid of current pay because once they do that They're probably going to be able to pay down some of that senior debt get their cost of of uh, that debt service down Might return the property to cash flow positive status

[00:24:46] And so they're going to be able to generate some cash flow in the in the current Market or the current day And they're going to use that to pay the pref equity and then When the project eventually, you know, hopefully sells They're going to have to pay back the bank first and then the pref equity and then the common And the whole game right now is sort of there's all these projects out there that are trying to limp their way through this tough time in commercial real estate

[00:25:14] Uh to get into some greener pastures where they can sell this thing for maybe 10 million 11 million 12 million More than what they bought it for us that they can pay everybody back but That's I wanted to provide some context there because you were talking about Rescue capital and pref equity and I just want to give some context in terms of Where that's coming from and I love your stall drag analogy because Before doing a pref equity deal like if you're going to be an investor in that wedged in save How much altitude do can you lose in the stall?

[00:25:43] I always say that altitude if you look at that that 172 analogy i'm sorry to cut you off Your altitude is your cash reserves So how long is it going to take you to burn through your cash reserves in a glide if your motor quit right? Yeah, and I wasn't really talking about cash reserves but I mean if if that asset is really actually worth six And they're wedging in You know a million and that and you're still upside down Like you could be investing pref equity into a deal

[00:26:12] That never recovers Right and then and then as a pref equity holder, you could not be paid that current pay Because usually the terms in pref equity is hey, if you don't get paid current pay Then you start getting ownership in the deal, but who cares your the deal's dead. It's upside down, right? So exactly I cash reserves is part of it But I would say that you know where I was going with it was You know You say the deal's worth 10 and now it's worth eight but really maybe it's worth five or six

[00:26:41] Or or maybe the cash flow can't even service the pref equity So even though there is a current pay there's still massive risk that you can't make that current pay and there's risks that you won't get so it's kind of like It's kind of like boarding a plane, you know is stalling, right? Right and so you have to like you're boarding you're getting on something that you a vessel that you know has a problem Right, and I would go into a deal like that wide open just being like hey We know that this deal has a problem

[00:27:11] And that i'm stepping in to fix it and I need to make sure that I have clarity on this plane having enough altitude to actually recover the stall And I have to know that the person who's flying the airplane knows how to do stall recovery Right, and so you know, how many times have they done this and what you know, and so it well trained and and things like that Because I think you know pref equity can be used a couple different ways

[00:27:38] Well, and before we get to that I really do want to stop and just say We're not trying to beat up pref equity here What we're talking about is rescue capital going into deals and typically The way that you would see Pref equity being offered the way that we're talking about it up until this point Is in a capital call situation. So you're already in a deal. It's not going well They need fresh capital to come in. It's usually in a new pref equity offering now

[00:28:05] Pref equity is not always a bad thing and it's not always rescue capital. There's actually very Advantageous ways to use pref equity in new healthy deals. So let's talk about that. Yeah, yeah No, I mean I you just have to know what you're stepping into right so like a pref equity deal could be Hey, like this deal like we we actually uh, you know one of our Deals that we did last summer The property management company cubesmart actually offered us pref equity right and and it was really really attractive pref equity terms

[00:28:36] Now I want to get into some of the ethics too But I just want to touch on that we could have started that deal with pref equity, right? And so and it was like, uh, I think like a Five or six current pay and maybe a four percent kicker at the end Which is like cheap pref equity, right? And that kind of sizes to the risk, right? Because they didn't view it as a very risky pref equity play The reason why we didn't do it is because we already had told the investors that they're investing in a common equity and a senior debt deal

[00:29:03] You know, it's it's uh, I understand when you know When you're desperate, you know, you kind of run out of options and maybe pref equity is the only way to go do that but You know when you're looking at being a common equity investor Or just you know the bottom of the capital stack the most risk the most reward I would ask your sponsor if there's any provisions that allow them to put pref equity ahead of you later on in the deal because if you could imagine it's it's like the the hawk circling the carcass like Yeah, okay

[00:29:32] I want to be a pref equity investor and i'm going to come in and i'm basically going to squash any hope That these common equity investors have to make a return And like sucks to be them but great to be me because i've determined this deal is awesome And it has a lot of altitude to recover from And i'm now ahead of these guys that have been you know These investors that have been in the deal for four or five years Pretty upsetting to those investors, but maybe those investors had a chance to invest on the pref equity side or maybe the

[00:29:58] Maybe the investment had a capital call and they tried to shore up money to try to save the deal and no one participated, right? So it's really important to kind of go into things and kind of understand What could happen in the future and ask if there's any provisions that would disallow that All right, i'm going to play good cop with pref equity because there I will I'm going to defend it a little bit because we did an apartment deal last year When we structured it from the ground up amazing deal, we bought it for

[00:30:25] I don't know 60% of what it would have been worth a few years ago The guy had owned it for 35 years unfortunately passed away. His heirs were selling it had they sold it a few years earlier They would have gotten a much better price for it but remember if you've listened to our episodes before you know that He would have paid capital gains tax and his kids get the step up in basis after you know a family member's death So the kids

[00:30:52] Inherited it they decided they didn't want to wait for the value to go back up And so we we got it a great basis The reason we did a pref equity piece in it was to appeal to different investor appetites You know, we primary the primary equity in the deal was common We peeled off Oh gosh, I don't know I think it was a 10 million dollar deal very small And I think there was about 3 million in common and about 1 million in pref

[00:31:20] And the way we structured it I think it was 8% current pay and then at the end they would get bought up to a 13 or something like that That was very attractive for a certain subset of investors Who were maybe in their Late 50s 60s in retirement and they're like, yeah, this is a great deal. There's a lot of meat on the bone, but like Ah, you know, I don't want to get greedy I'm happy with that 13% when the deal goes full cycle and i'm the first one in line to get paid After the bank, of course

[00:31:51] For the common equity investors, they have the opportunity to make 20 Plus percent on the back end. They're also getting some cash flow deals going really well But the pref equity investors are getting more cash flow With limited upside and they're first in line to get paid The common equity investors are getting a smaller amount of cash flow with a lot of upside As this project matures and if you're in your earlier And more gladiator phase of your career, you're making tons of money

[00:32:21] You don't necessarily need the cash flow and you're you're looking for more of those doubles and triples That could make more sense for you as long as you're comfortable with the the risk profile of that deal So I think having the option On a deal to either go hey, i'm going to take a little lower risk. I want to be first in line. I'm happy with this lower return or You know, you you look at the deal as a whole and you're like no, this is this is really healthy I like the deal overall and I can see that there's a lot of upside the pref equity

[00:32:50] People are not going to be participating in that upside The common equity people are yeah, I think you but what you're explaining though is you're explaining somebody who's who's offered a deal Transparently correct and which which is should be the case From the beginning, right? Like you're basically saying hey, i'm going to do this thing I just think the big takeaway there is like if you're a common equity holder and you go into a deal and you know There's pref equity Just know that you're now the and there's debt now. You're the third in line to get paid

[00:33:18] I would expect my return to be much higher Than a deal that comparatively didn't have pref equity Right and mathematically that's the case because if you were to Take that if you were to convert everybody in that deal. I just mentioned to common The return on the common equity would be lower because the cost of capital is going to be higher your roic Return on investor capital, right? Like that's where you're that's where you're kind of thinking and again Return on our on investor capital goes up with more leverage

[00:33:48] Or more people that are taking less right banks pref equity But your roic goes higher, but you it bears more risk Correct as you lower the leverage and you lower the people in line to get paid Your roic goes down. So that's why I just I cannot stand it when somebody's like Hey, ryan, we look at this deal at the returns are fantastic You know your deal pays 13% and that this deal pays 21% or whatever and i'm just like

[00:34:17] Well, first of all those are all projections first of all, they're all projections but like but but you haven't given any credence to how You actually are lining up in the capital stack and and who's getting paid when And what your risks are because it's it's kind of it's kind of a silly comparison When you don't have those factors, right? Right and I and I always love giving the analogy of like it's like skiing a ski hill, right?

[00:34:41] A common equity and senior debt with low leverage is like skiing the the greens the green circle. Yeah The green circle right easy peasy baby like no problem You want to go to the blue square? You lever up a little bit you want to go on the double black or you want to go on the black diamond Right now you're skiing you're having a good time, but like You could fall and hurt yourself and if you're not if you're not very good at skiing and this is your first time down the mountain Maybe avoid the black diamonds because you're gonna probably have

[00:35:10] Some senior debt maybe some second position debt, right? You go ski the double blacks And you're you're sitting common equity and you got prep equity and senior debt, maybe some mez debt You are skiing a double black diamond, right? And and you kind of better know what what's going on and and don't don't do that for your first one Maybe like it's okay if you do but like You you you just might be careful, right?

[00:35:35] Okay, so I want to flip now from talking about it from the investor's point of view To talking about it from maybe our point of view where we're we're putting deals together and What we typically do is we're going to identify an asset. We're going to figure out how we can make it worth more And by how much and then we sort we can sort of back into the capital stack What you don't want to do is take a deal that's already really risky Yeah, yeah

[00:36:04] And lever it to the hilt like right You know, we did for example We did a uh a land entitlement deal in colorado deal's going Fantastically But land entitlement inherently is very risky So the worst thing that we could have done was taking out a bunch of debt on that deal We bought that a hundred percent cash because that gave us Runway and breathing room and we were able to execute a fairly risky business plan on this deal

[00:36:31] Without the added risk of needing to make sure that the bank is paid so that won't lose everybody's money There are other deals that have inherently low risk Like let's say the houston storage portfolio a lot of of listeners invested in that Uh, that is a deal where now you start backing into okay Here's the deal. Here's how much it's going to make and now let's start start putting the layer cake together How much debt should we take? So I know that that one was actually fairly

[00:37:01] low Levered I mean, we probably could have gone a little bit higher on that deal Uh barton could have gone a little higher on that deal But what were the things that you were thinking about when you were structuring that capital stack ryan? Yeah, number one, I know that our investors want cash flow, right? So if I if I went in and said I want to put common equity and prep equity and senior debt on this thing I know that the Cash flow would have gone very low for the common equity investors, right?

[00:37:27] And so when you think about the cap rate you're paying on an investment and the interest rate that you're going to pay on the debt It gets harder and harder to cash flow when you have higher and higher leverage Like there's an advisor. We had brandon brookman who literally has deals called zero coupon deals and I won't I won't get into like the The reasons why he does them but Zero coupon is like high leverage No cash flow, right?

[00:37:54] And so when we were putting this together we thought hey, let's let's make it so the common equity investors are going to get some cash flow Also, this is a big deal. This is this is a hundred and seven million dollar 108 million dollar deal And we didn't want to take a lot of risk You know, we just wanted to make sure that we could cover our debt service And we wanted to make sure that we could execute our business plan The other thing that we that we strategically Negotiated into that loan is that if we were hitting a certain dscr at the end of year three

[00:38:23] We could actually go take more money out And that way like we could you know, if if the cash flow goes in the way that we want it to we could we could take more money Out later or not we have that option. So I think when you're thinking about you know how to leverage something I would decide you know when you're looking at something like low risk deal low risk underlying assets Proven track record and then you have low leverage You shouldn't be expecting crazy returns If you have an inexperienced operator

[00:38:51] I would say that I would expect more returns Yeah, if you have an inexperienced operator and a class b or worse asset class c class d whatever Asset then I would expect much higher returns if that operator then Levers the property up with all kinds of different layers of the capital stack or or high leverage And I consider and I know this is my personal preference. I consider anything over 70 being incredibly high leverage

[00:39:17] But that's just me. I know a lot of operators do like on the reg they do 80 or 90 But I I consider that risky um Those to me that would be like a 30 return, you know new operator highly leveraged low quality asset I would I would want to see something crazy on the returns Right in order to make it worth the risk of going into the deal or yes Now if I see experienced operator With low leverage On a class a asset

[00:39:47] I don't expect the returns to be very high Like I would expect, you know, somewhere in the low teens like maybe 13 14 percent And so that's how I size a deal and I think I think investors really this is so important because As you're as this pilot community gets more exposed to this type of stuff I think that's where we really have to get good at saying You know, somebody brought me a deal. I wouldn't even look at the you know, I wouldn't you know I would say okay, what's the sponsor?

[00:40:17] What's the debt? Where are you in the capital stack? What's the quality of the asset? But and then I would say, you know again, I would put it to my test Which is like highly levered inexperienced low quality asset I would say okay that that should be a very very very high return Right well and there's also, you know The the less experience the team has the less dialed in they have their numbers Um, and so they might be projecting a 30 percent return and then find out later like oops It's it's only going to be a 15

[00:40:47] Yeah, exactly and that's where like but as an operator. I mean, I Generally i'm i'm very risk adverse. I don't want to have you know Any deal i've ever gotten into trouble with in real estate has been because it was levered too much Yep 99 times out of 100 anytime you hear anyone say that they lost money in real estate It's because of the debt because of the debt every single time. Yep, and um, you know and it's and and or the ability to restructure the debt, you know There's some times where you know tate I know you and I are in a deal right now

[00:41:17] We're restructuring the debt and that makes it a lot better, right? And so um, and the only only thing i'd put on there is like, uh, you know Fixed rate versus floating that's like another big one Yeah, is you know is your senior debt or your mez debt a fixed rate or floating and I think that's You know if the if the debt can change right and I know for a minute We were in a lowering interest rate environment now It seems with the new fed and inflation and conflicts overseas. I feel like we're kind of in this

[00:41:42] I think we're predicting two rate hikes potentially through the end of the year Right, so I I think all bets are off. I think people kind of took, you know Floating rate became more popular Recently because everyone's like oh, yeah rates are coming down But I but now i'm kind of like we're looking at stuff and i'm still on the fixed the fixed interest rate I am too wagon, right because i'm like, you know, so You said something earlier dscr. I just want to clarify that so that's debt service coverage ratio

[00:42:08] That's essentially any any debt service coverage ratio of greater than one is basically going to be a surplus of thrust to drag So you're you're going to be able to clear your debt service coverage And you're going to have cash remaining Anything less than a 1.0 dscr you have a negatively cash flowing asset banks like to see about a 1.25x To call it a healthy deal anything more than 1.25 would be would be you know a big thumbs up You know, we talk about

[00:42:38] Risk and leverage in terms of loan to value or loan to cost dscr is kind of that same metric for cash flow So the higher the dscr debt service coverage ratio Is how much cushion you have on cash flow above and beyond the amount that it takes to service your monthly debt payment love it Well, this was a awesome Discussion I think so. I hope our listeners uh took away

[00:43:05] Uh, where are you standing the capital stack and and what what's going on with these deals and and and you know Mark our whole goal today was to make you a little bit more sophisticated And also expose you to some opportunities in real estate that maybe you didn't know about That's right because you can participate as Common equity pref equity You're probably not going to be participating a senior debt because that's typically a bank But before we go we should probably touch on mes debt or bridge debt

[00:43:31] Um, really mes debt because you could potentially see an opportunity to invest in some sort of a uh private credit fund Uh or or a mes debt fund that comes in as a secondary lender on projects Do we want to we want to touch on that real quick? Yeah, i'd love to I mean probably one of my favorite ways to invest frankly, um, you know I would consider mes debt like a private debt fund or something like that same Something that may or may not be in the first position. Usually it means second position as in like a mezzanine, right?

[00:43:59] A mezzanine level is half It's above right. It's not the ground floor It's mezzanine and so if you think about you know, you're coming in And you're getting some kind of a higher interest rate But you're also usually in a subordinate position, you know, you're not the first in line on the debt side But you might be the second in line on the debt side Which means that you may or may not be secured to the investment, right? You might not be secured to the property So if you lose if the property loses money and there's a foreclosure or something

[00:44:28] You might not have the right to file against the deed of trust or maybe you maybe you do it depends on how it's structured So I I would say, you know, if you're in the mes debt position Just understand the mechanics, right? Like where where are you? How does it get paid? What's the limits on ltv? You know things like that I would also just point out How much cushion of equity do you have behind you? because If the senior loan is At let's say 60%

[00:44:57] And you are in a mes debt position that accounts for 10 Then you have 30% equity behind you That would mean that the asset would have to lose 30% of its value for you to start taking a haircut That's a pretty safe position So, you know, if you're looking at the market and you're like, yeah, I don't really think that we're going to see valuations collapse by 30% Anytime in the near future I'm comfortable and i'm getting a nice, you know, 8-10% rate of return something like that That could be a really healthy

[00:45:27] Mes debt position to have in your portfolio Could yeah Now on the contrary if the senior loan was at 80% And you're in a Mes debt position that accounts for 15% And there's only 5% of equity behind you now the valuation only has to collapse by 5% and now you're you're losing money so The amount of equity cushion that is subordinate to you Matters a lot Yeah, and I would say this too like

[00:45:54] You know, I go to like local real estate meetup sometimes and you know, you you do run into you know To your point about not being a first position lender or senior debt lender Those opportunities are out there like I know a lot of investors that are hard money lenders, right? They hard Yeah, you know, I was going to mention that yes That would probably be the most common way to act as a senior lender Yeah, so so hard so hard money lenders can be first position, right and and that can be very lucrative Yeah, again where you get into trouble is you know, if you like you might be a hard money lender

[00:46:23] You might be investing in a hard money lender fund, right? So you have a manager who goes out and makes these loans and finds these projects and you're an investor in that And where I see they'll go wrong is they put a loan out of property that's highly leveraged The deal starts going poorly. So what do they do? They throw more debt on it throw more debt on it throw more debt on it To the point where there's debt is exceeding the value and then you can't get your money back Right, right But i've also seen people make a lot of money

[00:46:49] Right being hard money lenders because here's what's here's usually what you get to you get to have in first position, right? You get the first position loan At closing you get paid two three maybe four points So if it's a hundred thousand dollar loan, you're making four grand at closing if you're getting four points you're making 12 or 13 percent interest You're the only one in the capital stack, right the the Hard money Borrower to is is just trying to turn these properties as fast as possible and pay you back as fast as possible

[00:47:19] And then when that loan pays off They want to do another flip right another house. So what do they do? They borrow again for you at four points, right? So now you make another four thousand on your hundred thousand example And the interest in the interim along the way you do that three four five times a year You could be making 20 points On your hundred grand even making 20 grand just on closing points, right? And that's huge And you know that if they screw up that flip

[00:47:48] All you got to do is you know, you're you're the lien holder on that property now You're in first position. There's no other people involved Take the property back now. You probably don't want to do that Yeah, yeah, but you know, I know seasoned investors who do this Nine 10 20 times a year and make a whole business out of it You know the key there is you got to really know the market and I would probably want to live in that market Yeah, right and you're going to want to know the borrower as well

[00:48:16] They tend to crop up as these symbiotic relationships between flipper or builder and investor And they'll form this symbiotic relationship that lasts for five ten years And they just sort of follow each other from project to project That's how i've seen it manifest Totally and and so that that's a great way to be a first position lender Some funds will offer you the first position, right? You can invest in funds that do that You know, I I think there's been a lot of negative press about private credit funds as of late

[00:48:45] They were like yeah, sort of they were sort of like the in in style thing that everybody was doing because what was happening was And and private credit kind of falls in that mez debt category What was happening was you know, you were having these commercial real estate Deals get into trouble and then you'd have these private credit funds swoop in and sort of lend an environment where it was really hard to get lending And you know, I think with the blue owls, you know, you know

[00:49:10] You've you go blue owl and what happened there like a lot of investors started to ask for liquidity and they didn't have it Right, and so these loans were getting extended They were trying to get you know, investors were trying to call their cash back. They didn't have it Right, and so I think We've seen this sort of commercial real estate lending thing drag on And and a lot of these private credit funds haven't been able to offer the liquidity that the investors were sort of expecting so just know that like

[00:49:38] Redemptions are never guaranteed and you can't always get your money back and and and be careful because i've had a lot of investors Hey, can you look over my shoulder on this deal that i'm looking at? And i'm like hey ask about redemption, you know, what are the terms of redemption and they might say something like oh We've never not been able to redeem and it's like whoa, but what what if you can't right and that's a real risk let's I I do want to unpack this because We have a private credit fund and i'll just you know full disclosure

[00:50:04] And I want to make sure that people really understand this. I was just fact right conference in scottsdale, arizona A lot of broker dealers there and family office money And there's a panel on private credit and really everybody in the room was saying, you know The headlines on private credit are completely overblown These funds were never meant to be money market funds. So there's two issues One is the one that you just mentioned that and when you say money market what you mean is

[00:50:31] Money that you can just withdraw whenever you want, right? Yeah It's making a rate or turn you can click a button same day liquidity turn it into cash and put it somewhere else Private credit funds were never intended to be that way Uh, you know, I know that ryan you have a debt fund operates a little bit differently Uh, ours has a two-year lockup period and then 90 day liquidity after that But of course we always disclose that it is as we can you can think about it at like a carousel

[00:50:59] And or a ferris wheel where people are coming on to the to the carousel and people are getting off of the carousel And we've you structure a private credit fund with all that it's a huge basket of mes debt bridge debt We've got some pref equity positions in there as well. None of its rescue capital. It is all Um, you know, it has has super healthy just origination equity positions Correct. Yeah, correct And you stagger the maturities

[00:51:27] So that when someone says hey, I put 100 grand in this, you know a couple of years ago I want my 100 grand back out great. We've got a maturity coming up in two months There's going to be you know, some liquidity in the portfolio. We'll cash you out in 60 days. Oh look You know, john doe Just committed 100 grand into the fund Hey, do you want to be cashed out today? Sure Great and it's a drop and swap this person gets off the carousel this person gets on the problem is when everybody wants to get off at once

[00:51:55] it's sort of that run in the bank situation where You can't because you have this this carousel of all of these Staggered maturities happening within the portfolio and so that's how a private credit fund works And when it works the way that it's intended Then it's it's a beautiful thing because there's no volatility Investors are getting paid a fixed rate of return It's very very low risk But when people come into it with the wrong

[00:52:24] Idea of what it is. That's what creates issues. They say I want my money back and they go well Everybody's trying to get their money out right now. We can't yeah, and they go, you know, this this is a ponzi scheme It's like no, it's not it's just a you have to wait for all of those maturities to occur to get everybody off the ride Well, I think I think part of the problem too is that like I see it all the time on linkedin where people are like Yeah, and our private credit fund you can get your money back whenever you want and it's like no you can't That is wrong

[00:52:54] Yeah, if anybody says that in a private credit fund run the other direction because they are They're they're misconstruing The or or or over promising what they can deliver. Yeah, and ours is the same way So we we have a similar thing right our private our private debt fund is 90 day redemption So you can have a you can have an eight percent at 90 days Or you can have a nine percent fixed payment at two-year redemption Right, and I and I it's very simple the documents will tell you you can get into the legal disclaimers

[00:53:22] It says this right and I always make sure everybody says like hey, this is I just want to read your your rights here which is You can call your note back 90 days prior to our redemption windows, which we have a we have a window in february and a window in august So 90 days prior to those dates you can call it back if you're in the 90 day redemption period, right? And it's first come first serve and it's only if money's available Right is kind of like the thing if there's not money is available. We can't make further loans

[00:53:50] So if we get to your redemption window and we can't redeem you We can't make any more loans with that fund until you're paid back and that sort of stops the fund from lending out additional money right until We've paid you back Which is in the redemption queue The other thing is two years right where you get a little bit more interest But you're also tied into the fund a little bit longer think about it's like kind of how the yield curve works, right? Like longer longer time more money

[00:54:16] Two-year thing and then 90 days after that two redemption windows you have to go between each one redemption window So if you're not getting that kind of an explanation of how redemption works You should probably be concerned A hundred percent if anybody's saying oh, yeah, you get get your money back out at any time It's like no you can't and and that's that's why There's all these headlocks. Yeah, there was a guy selling a timeshare or a a portion of a pilates or something a pc-12

[00:54:42] And and it and he's like yeah, and you can get your money back after a year And and and I was kind of helping the guy looking at the deal I was like, well, can you ask him ask him? Ask him what happens if he doesn't have the money to give you back And he's like, oh, well, we've always had the money, you know, we've never had an issue Well, of course when everything is perfect, right? And like in the blue owl situation, I don't know All the details, but I probably could imagine that it's a big fund They probably had some mark to market reporting come out and the values of that real estate. I think we're going down

[00:55:12] And the loans were pretty high and so investors were probably looking like oh crap They're running out of runway Right, and I want my money out before the thing shuts down on me And so that's the thing is like when everything's going great. Nobody wants I mean You might have redemption requests here and there But when everything starts to go to crap, that's when everybody wants to call their money back Same thing happened with blackstone on their b-reate during like 2023 Everybody was trying to get liquidity had nothing to do with their performance

[00:55:39] And so they were like there was all these requests that came in and then that just begets more requests, right? Because everyone's like, oh my god, everybody Everybody's trying to get their money out, you know, and then like, oh, I want to get my money out And then everybody starts running to the back of the room to get their money out. So It's kind of like, uh, what's that show? Um Mary poppins great scene Run on the bank Right, and I think like the kid says something or whatever. I don't know. I can't remember the uh, dick van dykes in there

[00:56:06] And he's the banker and it's really funny, but like that's that's the panic that gets created Then it creates headline panic and then like you said tate like the panel was just talking about it, but Yeah, but then at the end of the day you you read between the lines You actually look at what's happening and there really isn't an issue except for for a small number of funds Private credit is operating exactly the way it was intended to And investors just need to come in eyes wide open understanding that is not a money market fund

[00:56:33] This is a longer term play where you're locked. You you are locking your money up for a little while. Yeah, but You know, they're very low risk and they pay a really nice rate of return A huge proponent of private credit funds Well, I think we're gonna try to end it again So tate this was good. We're we're uh, we're at an hour here. Uh, that's right, you know Thanks for following along with us while you make your commute to work or your drive to the airport or wherever you might be If you want to jump into more conversations, you know join our facebook group or

[00:57:02] Join the conversation, uh Or send us an email. We'd love to talk to you about any of this stuff tate and I are happy to look at a deal You're looking at or or look at um, or answer any questions that you have if something that you're you're evaluating So very good stuff. Excellent. Well, thanks ryan. This has been a blast. See you on the next episode the capital stack the capital stack See you then