A debt deal paying 10 percent beside an equity deal targeting 14 percent IRR, why would anyone take the equity

Question

Two offerings sitting side by side on the same platform. One is a senior loan on an apartment building, 10 percent annual interest, 24 month term, $1,000 minimum. The other is equity in a retail center, 14 percent target IRR, five year hold, $5,000 minimum. Put $10,000 in the debt deal and the investor makes roughly $1,000 a year and gets paid before anyone else. The equity deal is four points better on paper and that investor is last in line. So is the extra four points simply the price of going last? The part worth unpacking is a claim that comes up often: the 10 percent and the 14 percent aren't the same kind of number at all and shouldn't be subtracted from each other. Plenty of platform investors read that and think 10 percent is 10 percent and 14 percent is 14 percent. What does the distinction actually mean?

Rena Guide · Accepted Answer

They aren't the same kind of number, and the difference is worth getting straight before you allocate anything.

The 10% on the debt deal is a stated interest rate. The borrower owes it, it's written into the loan, and it doesn't change if the apartment building does better than expected. Your upside is capped at 10%. Your protection is position: the loan gets paid before the equity sees a dollar, so the property has to lose a lot of value before you're impaired. Stated is not the same as received. If the borrower stops paying, the platform or the servicer has to work the loan out, and your 10% becomes whatever the recovery is.

The 14% is a target IRR. IRR is a return that accounts for when money moves, not a yearly coupon. In most equity deals the cash distributions during the hold are small, maybe 4 or 5%, and the rest of that 14% only exists if the property sells for what the sponsor projected. So it's one number describing five years of modest cash plus a lump at the end that may be bigger, smaller, or absent.

So the four point spread is partly payment for going last and partly payment for accepting that the number is a forecast rather than an obligation.

One thing to check on each: whether the target is quoted before or after the platform's fees and the sponsor's promote, because the same deal can be advertised either way. Ask the platform in writing which it is, and ask what the equity deal's preferred return is, meaning the share of profit you get before the sponsor takes theirs.

megan_doyle15 · Answer

So the 14% is basically a guess and the 10% isn't? That reframes the whole thing for me, I'd been treating both as menu prices.

dmitri_248 · Answer

@megandoyle15 that figure is a projection, built from the sponsor's rent growth and exit cap rate assumptions, both of which sit in the offering documents for anyone who goes looking. The part to flag for @hannahwest29 is the waterfall. A 14% target with an 8% pref and a 20% promote over the pref means the sponsor takes a fifth of everything above 8%, so if the deal only hits 11% gross you are seeing something closer to 10.4% and you took equity risk to get the debt return. The debt deal has no waterfall at all, which is why its documents run forty pages instead of a hundred and forty.

sonia_alvarez · Answer

The senior position matters more than four points suggests. On a loan at 65% of value the property has to drop 35% before your principal is touched, and you are first in the recovery line. What I would want to know before comparing them is whether that 10% is a whole loan or a fractional interest, and who has the right to foreclose if it goes sideways. Usually it is the platform's affiliate rather than you, and you are along for whatever workout they choose. Also 24 months versus five years is a real difference, since your capital comes back and can be redeployed twice in the time the equity deal is still holding.

A debt deal paying 10 percent beside an equity deal targeting 14 percent IRR, why would anyone take the equity

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