To understand common equity, one must first understand how equity and debt differ. Debt, as we all know is money that is provided by a lender that is expected to be returned in full with interest. Equity is an ownership stake in a company or other type of investment. Depending on the type of equity, investors receive a percentage return on their investment that is outlined in the purchase agreement.
What Is Common Equity?
There’s a blend of equity and debt in the commercial real estate capital structure. Common equity is one of four portions of the capital stack and lies above preferred equity, followed by mezzanine debt, then senior debt. Commercial real estate developers and investors use common equity to close the gap between what senior debt is willing to contribute to the deal (usually up to 75%) and the remaining capital needed.
Managing property partners ultimately have the final say on funding the project. They could rely entirely on private equity (which usually falls into preferred equity) to secure the remaining capital, or just common equity, or a blend of both. Sometimes there’s even mezzanine debt thrown into the mix.
How Does Common Equity Work?
Common equity holders see returns on their assets only after senior debt and preferred equity investors have been made whole. The remaining value of the property is then distributed among common equity shareholders.
Common equity works in this manner in commercial real estate because the primary collateral behind senior and mezzanine debt is the property. If a deal goes south, the senior lenders can foreclose on that asset.
Equity comes into play for preferred and common equity as property developers and investors create a company (LLC) to channel funds through. Common equity is last in line to receive a return on assets after preferred equity. An upside to preferred equity is that PE investors claim ownership rights to the LLC during financial turmoil to either try and right the ship or sell to cut their losses. Common equity investors, unfortunately, don’t have the same benefits.
Benefits of Investing in Common Equity
While common equity might seem like a very risky investment position at first glance, there are a few upsides that are hard to pass up.
High Rates of Return
From an investor’s perspective, common equity has among the highest rates of return of any investment opportunities around. According to AB Capital, annual common equity returns can be as high as 25%.
Unlimited Upside in Prosperous Times
Unlike debt or preferred equity, common equity doesn’t have agreed-upon payoff dates or exit strategies. Suppose an investor does their due diligence and purchases common equity in a sound commercial real estate venture. In that case, that investor will see high returns in perpetuity for the life of the LLC.
Downsides of Investing in Common Equity
When it comes to the downsides of common equity, there is really only one.
The primary risk of common equity concerns its high returns. Common equity sees such incredible rates of return because the riskiness of the investment is quite substantial. Essentially, if an investor doesn’t do their research and purchases common equity in a bad real estate project, there are no safeguards to hedge losses when the property goes south. With the opportunity to make great returns also comes the risk of losing everything.
How to Calculate Common Equity
Calculating common equity on a balance sheet is relatively easy. Common equity equals the overall cost of the project, less debt (senior and mezzanine), and preferred equity.
Overall cost – (debt + preferred equity) = common equity
Not all commercial real estate deals involve preferred equity. In that case, it would just be the overall cost minus debt.
For example, assume a developer’s overall cost of a townhome development project is $10 million. The senior debt lenders give 70% of the capital needed ($7 million). If the developer didn’t seek out any preferred equity investors and relied only on common equity to cover the gap, common equity would be $3 million.
Is Common Equity Right For You?
While commercial real estate investors should thoroughly research all aspects of an investment before taking the plunge, this rings true the most for commercial real estate common equity because of the high levels of risk. However, if you’ve done your due diligence and trust those in charge of the property, you will see excellent returns on your investment. However, if you’re a very risk-averse person, you might want to steer clear of common equity.