Rob Beardsley is Managing Partner of Lone Star Capital. With his team, they have acquired over $300M in Multifamily properties across Texas. I have the pleasure of knowing Rob personally, and Lone Star has given me the opportunity to partner with them on several deals in the Houston MSA which are performing according to budget.
Rob wrote his 1st book The Definitive Guide to Underwriting Multifamily Acquisitions as well as created his own Underwriting Model which he offers for free to anyone interested.
In December 2022, Rob launched his 2nd book, Structuring Debt and Raising Equity. Below is a summary of this book
The book is 2 Parts as the name suggests. Part I focuses on various debt offerings and offers details at a beginner level. He then highlights exactly how Lone Star Capital uses these existing products into deals in real time with a nuanced approach.
This flows nicely into Part II which is the larger portion of the book and directed more toward sponsors and capital raisers; however, is a good lesson for potential investors on the details they need to be aware of (that they may not be) when considering an offering.
Lone Star uses 3 keys to purchasing a Multifamily Property: buy at the right price, with the right structure and incorporate the right management. This fits well with Bridgestone Capital’s 3 Pillars of Investing: Buy Right, Finance Right and Manage Right.
This book focuses on the capital stack structure or the finance portion.
For LPs/Passive Investors understanding debt structure will allow you to create an investment criteria and determine which deals fall into this category as they come to you.
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2 Primary types of debt:
Permanent and Short-Term
- These are 5 year terms or more and based on actual financials (T12).
- Useful for no value add or small/modest value add component.
- Agency debt is federally backed by Fannie/Freddie; but, originated by licensed lenders who have varying standards of underwriting.
- The agency’s aim is provide liquidy to housing market and support affordable housing. Receiving quotes from various lenders is useful due to their different underwriting standards.
- This is bridge-debt used for value-add or deep value-add properties, including those at less than 90% occupied.
- Bridge debt is provided through a CLO (Collateralized Loan obligation)
- It has floating rate and higher interest with varying terms among lenders
Negotiation points for Bridge Debt
- Personal Guarantee
- Interest reserve replenishment and Construction Completion governance
- Lenders will often want signers of the loan to personally some or part of this portion of the loan
- DACA (deposit Account Control Agreement )
- Also known as a lockbox (this gives account control to the lender)
- It is in the interest of the sponsor to keep control of the receipts and not allow the lender to get this or to mitigate this if possible.
- The recourse portion of the loan, meaning that the lender can sue the borrowers in the event of default. Some lenders will allow negotiation to partial recourse.
- Interest on Unfunded Capital
- The lender should not charge interest on unfunded capex. Ensure this is negotiated.
- Index floor on Floating Rate Loan
- Lenders want to prevent rate going under current pricing.
- This is a difficult negotiating point, but possible.
- The longer the term, the more favorable to the sponsor.
Fixed & Floating
- Great terms
- Eliminate interest rate risk
- Prepayment penalties (Yield maintenance)
- Calculated based on interest rate, prevailing risk free rate and remaining term
- The higher the 10 yr treasury = lower PPP
- Step down PPP is also an option: but comes with a higher interest rate
- Research shows least interest paid when FR is used
- This option is more flexible
- PrePayment penalty is straightforward, typically 1% of the loan amount
- Hedge on interest rate can be purchased through caps
- Rate caps have increased recently due to volatility in market
- The closer the cap is to market, the more expensive the cap
In order to structure the appropriate debt, first, identify property type and business plan (A,B,C,D value add). Consider leverage compared to purchase price. Items to consider:
- Is capex included in the loan ?
- Does leverage and term match business plan / exit strategy
Pref equity is a financial instrument used to build leveraged real estate capital structures. This receives priority on distributions and return of capital subordinate only to senior loan. While the senior loan offers 70-80% LTV, the pref equity can bring this up to 80-90% total, making the total capital raise only 10%.
You have a property under contract, know what your business plan is, now it is time to secure a loan. You must present loan package which should contain below key elements:
- Property Financials
- Pro Forma / business plan
- Purchase price
- Capex budget
It is important to add information about the sponsorship team and track record, especially KPs (Key Principles) that will be signing on loan.
Lenders will underwrite to in place rents but proforma expenses. Therefore, it is important to make a business case of how you will lower or maintain expenses in your presentation. Having a strong story is imperative along with a strong team that was assembled well in advance.
Introduction To Equity
Two Primary Forms of Equity
Common and Preferred
- Does not have seniority.
- Riskiest portion of the capital stack.
- Sits in 1st loss position.
- Benefits most on upside because unlimited profit compared to debt and pref earn fixed rate of return.
GP ( Sponsor)
The sponsor’s role in a deal is to: find the deal, debt, equity, manage the operations and distributions. The Sponsor will incorporate fees and allocate performance compensation.
The LP role is only providing capital.
- Priority over common equity
- Earns fixed rate of return
- Has default remedies/ control rights
- Subordinate to senior loan
- Similar to pref
- Different in legal structure
- Investors hold pledge of equity as collateral
- If a mezzanine borrower defaults, the mezzanine lender can obtain ownership of the pledged entity via UCC foreclosure.
These two equity options are good for low leverage value-add deals. However, having pref equity in a deal can pose a challenge to raise common equity due to increased leverage and reduced position in the capital stack.
Dual-Tranche equity structure
Puts equity into 2 groups:
- Class A Pref – Fixed return
- Class B Common
Class A trades upside for a more stable fixed return.
Class B can only receive cash flow after class A returns are paid.
This structure can make sense to help raise capital but not be more profitable. With this structure common equity typically receives lower cash on cash but larger overall profit.
Considerations when a deal has / needs Dual-Tranche Structure:
*Sponsor should consider: is a deal worth reducing compensation?
*Investors: is sponsor fee focused?
Elements of typical Equity Structure
The Multi-Class Equity Structure provides more than one investor tier for common equity to incentivize higher minimums from retail investors.
Class A & B
Class A – Minimum $100,000
8% Cumulative Pref
15% IRR (target and deal dependent)
50% Promote thereafter
Class B – Minimum $500,000
9% Cumulative Pref
Remaining distributions equal
The additional Pref for Class A is funded from GP shares, not LP; therefore there is no “loss” from investor profits for not participating in higher tier.
Sponsor Fees are important part of compensation for sponsors
Typically, they are 1-3% of the purchase price
Also capital placement fee is 2-5% of the equity raised
This fee is less common.
Waterfalls are a profit-sharing structure
The foundation is the preferred return (minimum threshold provided to LPs prior to the payment of any compensation to the sponsor
Compounding – shortfalls are not simply accrued but accrued with interest at preferred interest rate
Non-compounding – No penalty for sponsor for not meeting pref return distributions
The pref may also incorporate return of invested capital meaning passive investors are entitled to pref + 100% of original investment prior to any profit-sharing with sponsor
This is additional protection to the investor
Lonestar Capital waterfall: p. 49
Refinance -> first to pref then to the capital accounts (to pay back investor principal) does not reduce ownership percentage in deal.
Some structures allow sponsor to buy out investors through refinance. In this scenario, the LP enters a deal at the highest risk point and sponsors enter at stabilization. This is not a waterfall structure. A waterfall structure puts investor capital at priority over sponsor compensation.
Waterfall structure has downside incentives for sponsor to sell sooner. The solution is promote crystallization. In this structure, the sponsor capitalizes on value-add and receives promote before the asset is sold.
The promote to sponsor is awarded through increase in ownership percentage instead of cash which will increase cash flow, allowing the asset to be held longer.
The process includes a hypothetical sale with valuation and net proceeds run through waterfall to determine sponsor ownership.
1. Retail (High Net Worth Individuals)
Contribute $50-250k each. The smaller check size grants no control over major decisions. Retail Investors have a lower return hurdle than JV/Institutional
Retail Investors tend to be more capricious and will commit and back out more quickly
Capital partner that provides LP Equity by raising retail investors
This can be the most expensive way to raise capital delivering returns to LP + giving the GP compensation to Co-GP
Co-GPs are paid portion of the promote on a prorated basis
If a Co-GP delivers more than half (51%), they will want half the promote as well as their share of fees
Other value-adds can be beneficial in Co-GP model such as due diligence, Earnest Money, Lender deposit and 3rd party reports.
A Strong Co-GP can co-sign the loan satisfying lender requirements of net worth which is typically = to the loan balance.
3. JV / Institutional Capital
These partners are selective on markets and have a strict investment criteria. Institutional investors are looking to partner with someone they know, like and trust and the numbers must meet their rigorous requirements.
JV partners are very selective due to how many sponsors are vying for their capital.
In a JV, the JV Equity partner is an LP and you (sponsor) are GP.
But,the LP has major decision rights such as decision to refinance, sell and capital expenditures. LP & GP have separate classes of ownership as well as separate accounts.
It is almost impossible for the sponsor to earn cash flow promote with an IRR hurdle. The cash flow is 1st paid to satisfy pref and surplus goes to investor principal.
*this is used @ Lone Star Capital on deals and sought on deals we will partner on at Bridgestone Capital*
4. 1031 Exchange
1031 is a major tax benefit allowing for deferral of capital gains by exchanging for like-kind property upon sale rather than receiving all sale proceeds in taxable cash.
The interest in a venture is via TIC – allows investor to exchange interest upon sale regardless of actions of other members in the venture.
The 1031 takes direct ownership and this equity type has complications to work out in process specifically with lender requirements.
Return Expectations (Metrics)
Typically sought by retail investors
2-4% premium on IRR for bridge debt
Increases or decreases based on quality of asset, I/O debt vs. amortization, Hold period, loan assumption
Considered by Rob to be THE MOST IMPORTANT return metric
Purchase Price + CapEx
This is the truest form of valuation for an investment as it removes all clutter. LSC targets deals with minimum 5% but up to 7% YOC.
Raising Retail Equity
This is made up of HNWI seeking diversification from stocks or generate Cash Flow.
2 Factors influence amount of Retail Equity:
- Size of your investor Universe
- Degree they like and trust you
Increasing the size of the investor database is a top of funnel exercise. Creating a thought leadership platform is an effective means to build a loyal following. Offer giveaways to entice people to give their email and phone number. And, of course, being active on social media.
Continuing to offer value will increase the trust factor with your database. Offering value in the “middle of funnel” is a good practice. Setting up a phone call or additional e-books and case studies can prove useful.
Writing a book (like this one) is rare and shows you as an expert in the field and investors will associate this with trust as well.
Have your company and team information ready with your story, ready to present. Also, have a set of case studies readily accessible to the investor to prove to them that you are prepared and have a track record of success.
Raising JV Equity
Rob shares that the strategies to raise institutional capital are the same as retail with consistent and value-added marketing. Sponsors should put effort into both, as institutional capital becomes more accepting.
He has had a lot of success through LINKEDIN and press releases announcing debt and Equity partners.
Rob reaches out cold with a deal under contract which creates action to underwrite and receive feedback. It is important to have a focused strategy and single-market expertise with well-organized track record. A smaller, more focused approach is better until you are proven then you can expand your markets and asset classes.
Institutional investors prefer large growth markets and assets that are 1990s build or newer. Other notable items institutional capital prefers:
- Track record existent (not robust is ok)
- Use case studies
- Professional team
- Vertical Integration is a plus
- Ensures focus on the asset
- Institutional grade reporting
- Thorough and on-time
- UW vs. Actual
- Budget vs. Actual
- Cash Position
- CapEX Position
- CapEx Budget + Operating Capital
- good to include capital expenditures section outlining plan’s progress, how much has been expended and actual line-item costs
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As a top-performing sales professional in supply chain/logistics for almost 20 years, Jeff Davis has been putting his commissions to work for him in real estate since 2015 and is now partnered in almost 2000 units across 4 states in the US.