The AAA Storage Podcast

Welcome to the AAA storage podcast,
your integrated real estate and

development partner, exploring all
things, self storage investing to

bring you diversified success.

Let's dive in.

Brandon Giella: Hello and
welcome back to another episode

of the AAA Storage podcast.

And again, we have the wonderful
and inimitable Paul Bennett.

Thank you for joining.

I am so excited to hear about this
topic today because we are going to be

talking about the capital stack As it
relates to investing in real estate So

there are lots of different ways that
you can get in on an investment Deal,

so there's of course there's debt.

There's equity.

There's different kinds of debt.

There's different kinds of equity And
you mentioned before we started recording

that You know, there's, there's ways to
think about it from a risk perspective.

There's ways to think about it
from a type of capital perspective.

There's ways to think about it in
terms of who gets paid out first in

the event of a waterfall or exit.

So Paul, I'll turn it over to you.

Help, help us, me, investors listening.

Tell us a little bit about the ways that
you can invest the different types of

capital and the ways that you guys think
about financing some of these deals.

Paul Bennett: Absolutely, Brandon.

And as always, it's good
to have some time with you.

As I thought about the capital stack in
preparation for the call today, I chose

to go at it in what might be an inverse
order to try and give investors an idea

of their offerings at all levels of
the capital stack in the market today.

Um, but to try to give the investors
a, an understanding of sort of risk

and return and features benefits
and so as they're reviewing multiple

offerings, they can see and understand
the difference in, for example, senior

debt versus preferred equity versus
mezzanine debt versus common equity,

uh, and what each offers an investor.

And I can't Um, help, but also maybe
put a little bit of insight in there

from a sponsor perspective because,
um, there are, there are reasons why

those different areas in the capital
stack are attractive to sponsors

or, or not attractive to sponsors.

So, yeah, we're gonna, we're gonna
attack it from an inverse order.

Really starting with the part of the
capital stack that has the least risk.

Which is senior debt.

Um, senior debt is, is debt that
is secured by a deed of trust.

Um, and secured by the property itself.

It typically carries the lowest
return in the capital stack, but

also represents the lowest risk.

Because as a lender that has a, a
lien or deed of trust on the property,

if something were to go wrong in the
deal, you have the right to, to take.

possession of the property in order to to
repay the debt, the loan that you've made.

And and typically, for example, in self
storage, we're required to put at least

somewhere around 30 percent of the
cost of a project into it as equity.

So you've got a 30 percent buffer.

If you're the senior lender, that that
project has to be, you know, worth

70 percent of its projected value.

It's cost to construct before the
senior lenders exposed at all.

But they're protected by, like I
said, a deed of trust and a lien,

a promissory note on the property.

And there are tons of senior debt
funds out there today that are offered

investors the opportunity to invest with
a sponsor who's then going to in turn

loan that money, uh, to a developer or
someone that's acquiring real estate.

And the senior debt typically
carries current cash flow.

In other words, you're going to get a
quarterly or a monthly dividend that

that's reflective of the interest rates
that the debt fund is charging And in

some cases they're going to provide some
liquidity You're going to be able to

resell your your interest or your shares
in that debt fund to the sponsor and

and get you know, get your cash back.

Um, not all funds offer that, but a lot
do, but it's a lower return in today's

environment, probably somewhere in the
67 percent range in terms of return.

Um, but lower risk and in some
cases does offer some liquidity,

which is not common in real estate.

Real estate is generally an
illiquid asset, and you know, you

really don't get true liquidity
until you sell the property.

Brandon Giella: very helpful.

Okay.

I just want to preface a
lot of what you're saying.

You know, I have an MBA and went through
a bunch of finance classes and it was all

very confusing to me and there's so many
details, but what you're providing gives

a very, very good summary and also like
interest, like why does it matter what

kind of investment vehicle you choose?

I think it's really, really helpful.

Paul Bennett: The easy analogy, Brandon,
is, is everybody listening to this?

Podcast probably has a
mortgage on their property.

Um, and the lender that loaned them
the money to buy that house is the

senior debt in their transaction.

And as we all know, if you don't pay the
mortgage payment, Um, ultimately they'll

come knocking and they'll take your
house from you and, and In their case,

they'll resell it and hopefully get their,
the amount that they loaned you back.

Um, and, and essentially in commercial
real estate it's really no different.

Obviously, uh, the risk is a
little different and the terms

are often quite different.

But it's the same thing.

It's the senior debt, it's
the senior lender that has the

first lien on the property.

Um, and is in the most protected
position of anybody in the capital stack.

Brandon Giella: That's great.

Okay.

Perfect.

Okay.

So what's next?

If you're not doing senior
debt, what's the next level up?

Paul Bennett: Remember, we're kind
of going bottom up, if you will,

but the next step in the, in the, in
the capital stack is mezzanine debt,

or often referred to as mezz debt.

And it's basically, since I use the
homeowner analogy, it's a second loan.

It's like a HELOC.

It's like a home equity loan, um, which is
in a second position to the senior lender.

So, um, if the property were foreclosed on
by the senior lender, um, and the proceeds

from the sale only, enough cash to pay
back that senior loan, the mezzanine

lender would be left holding the back.

Um, so it's a little bit riskier.

Um, it's, it's quite common in
corporate finance, and in fact in

corporate finance, mezzanine debt often
also includes an equity component,

like warrants to purchase shares,
or other equity like mechanism that

gives the mezz debt a little upside.

That's not really common in the
real estate world, and it really is

additional leverage over and above.

what the senior lender is willing to
do, um, and therefore, because it's

a little riskier, provides a little
bit higher return or interest rate.

Um, then the, the mezzanine,
I mean then the senior lender,

and it's often shorter term.

You know, senior debt may be on a 20 year
amortization or a 25 year amortization.

Um, in today's world in commercial real
estate, shorter am, longer amortizations

but shorter terms are not uncommon, a 5 or
7 year term with a 25 year amortization.

Mezzanine debt is usually
shorter term in nature, probably

five to seven years or less.

Um, in in most cases, uh, and it
does carry, like I said, a little

bit higher rate because it's a
little higher risk for the lender.

Um, and, and it's not quite as common
in small to medium sized commercial

transactions, more common and very large.

Um, I'm talking, you know, 100
million and up transactions.

Um, and it's not an area.

They're not as many offerings for
investors, particularly high net worth

investors in the mezzanine sort of
tranche of the trap of the capital stack.

Uh, but it is there and it is
used in commercial real estate.

Um, and it just falls second
in line in terms of risk.

Um, it's second in line for
a sponsor in terms of cost.

It's less expensive than
preferred equity or common equity.

But more expensive than senior debt.

Um, and so it's, it is used, you
know, Fairly commonly in commercial

real estate, it's something that we
typically don't do in any of our funds.

Our funds are, typically our
capital stack is very simple.

It's common equity and senior debt, which
is not uncommon in the real estate world.

But, uh, the mezzanine piece is an
interesting piece, a little bit of

a hybrid, uh, that does provide a
little bit of additional return.

Uh, and there are mezzanine funds out
there for investors who want to invest

in that tranche of the capital stack.

Brandon Giella: That's really helpful.

The, the mortgage to home equity line
of credit kind of look, um, and that

cause I I've always heard of it in a
venture, uh, Kind of context is the

way that i've studied it where it comes
typically later stage in a raise round

for a company um, and it's a lot more
creative a lot more interesting, but

you saying it's it's like the second
stage like a Helo, that's really helpful

Paul Bennett: Yeah, it's, it's, I mean,
it's a first, it's a, it's, it's a,

there's a loan in the first position,
which is senior debt, has the least risk.

And then in this case, if you're using
mezzanine debt, it's a second loan,

like a second mortgage, um, that,
that, in fact, it is a second mortgage,

even in commercial real estate, that
stay, it's subordinated to the senior

debt, um, and, and in often cases.

Um, the senior lender will require
certain conditions be met before

the mezzanine lender can be paid.

Sometimes it'll allow interest
payments, but no principal payments,

um, unless certain conditions are met.

Um, but it is a second lien
on the property that stands

behind the senior debt.

Um, and there's some interesting
opinions on mezzanine debt.

If it is used in an attempt
to over leverage A property.

I think it carries a
tremendous amount of risk.

Um, leverage is a two edged sword, right?

It, it increases returns on equity, um,
but it also can overburden a property and

make it very difficult for that property,
if something doesn't go just right,

to meet its debt service requirements.

And when you do that, you expose the
other part of the capital stack, which

is the equity part of the capital stack.

I'll tell you, I cut my teeth in the
real estate industry, and particularly in

real estate syndication, started in 1981.

And from 1981 to 1986, there were a
lot of tax motivated transactions.

And they were, they were really
designed to create write offs for

investors, more so than they were to
provide really solid economic returns.

Not, not all of them, but a lot of them.

And so, in order to boost the tax
benefits, um, there was a lot of leverage

in those, a lot of those transactions.

And mezzanine debt was probably
even more common then, because

you had senior lenders that would
only go so far, but a sponsor

wanted to really lever the deal up.

Um, and, and, and create a
disproportionate amount of tax benefit

relative to the equity in the deal.

Um, and about 19, not about, in 1986, the
government passed TEFR, the Tax Reform

Act, um, that changed a lot of the rules.

And you saw a lot of those over levered
deals hit the wall and explode, uh,

because they simply couldn't sustain the,
the economics of the project with the

cost of debt that they were carrying.

So, um, I think it's, it's, it can be.

Um, I think it's a positive thing
and it can be a good place to invest.

Um, but I think it's a place to invest
with some caution because if you

think you're making an investment that
has very limited risk, um, and it's

mezzanine debt, that may or may not
be the case, if that makes any sense.

Next

Brandon Giella: going back to the 80s
because you've been investing in real

estate longer than some of our listeners
Including yours truly have been alive.

So I think it's amazing.

Okay, great.

Thank you.

Okay.

So what okay so next next step is
okay mezzanine and then there's

Paul Bennett: Yeah, so senior debt
is the lowest risk and lowest cost in

terms of sponsor cost or, or owner cost.

Mezzanine debts, yeah,
we, we talked about that.

The next tranche in the capital
stack is preferred equity.

Uh, and preferred equity
is an interesting animal.

Um, because it is equity.

Uh, but it, it, it sits in the capital
stack from a waterfall standpoint.

And by waterfall I mean if you
sell a piece of real estate.

The first guy to get paid
is the Senior Lender.

The second guy to get paid
is the Mezzanine Lender.

The third person to get paid generally
is the Preferred Equity Investor.

Um, so it stands in front of the
Common Equity in terms of risk

exposure and distributions upon a sale.

Um, the difference between Preferred
Equity and Common Equity is

that Preferred Equity typically
carries a fixed coupon or return.

Um, it, it depends on how the deal
is structured, but in some cases, um,

some of that is, uh, paid actively.

So, in a, in a preferred equity position,
maybe the total coupon is 12%, and

6 percent of that is paid actively,
and the other 6 percent is accrued

and paid when the property's sold.

But in all, you're gonna get a
12 percent annual return on your

investment, but it's a fixed interest.

It's, it's, it's, it feels in
some ways like debt because it

has a fixed coupon attached to it.

Um, but it functions like equity because,
um, you're standing behind the senior

lender, uh, and the mezzanine lender.

You do not have a lien on the property.

And, and if the, if the waterfall
upon a sail doesn't get to you, in

theory you can lose all your money.

Um, and that's really not.

Realistically, not the
case with a senior lender.

Maybe the case to some degree for a
mezzanine lender, but the preferred

equity investor is generally more
exposed than either of the debt

tranches in the capital stack.

Um, but they're going to get paid
before the common equity does.

Um, and, uh, like I said,
usually carries a fixed return.

We've even considered adding a PREF
equity class in our fund structure.

Uh, we may look at it for a future fund.

From a sponsor standpoint, senior
debt's the least expensive, mezzanine

debt's a little bit more expensive, PREF
equity, a little bit more expensive yet.

Um, but all three are significantly
less expensive than common equity,

particularly in a project that does well.

Because the difference between
preferred equity and common equity

is that there generally is no
fixed return for common equity.

Um, and you're totally exposed in terms
of the possibility of losing all of your

investment, uh, if the other tranches
in the capital stack can't get repaid

through the sale of the property.

However, in a property that goes
well, your upside isn't capped.

Um, you're going to get whatever
proportion of that common equity

distribution, um, that you're entitled
to based on the sharing arrangement

and the, the, uh, waterfall within
the fund or entity that you invest

in, but there is no cap on that.

Um, and so ultimately in a project
that performs very well from a

sponsor's standpoint, that's the
most expensive capital of all.

Um, and as I said in in our current
fund, and, and right now as planned in

our future funds, we really only have
two of the four tranches of, of the

capital stack, uh, in our capital stack.

And that's.

Common equity and senior debt, uh,
with no MES debt or preferred equity,

you know, in between those two.

I hope I've done a decent job of sort
of explaining the differences in them.

Uh, I feel like sometimes I'm maybe
not quite getting all the way there.

But, um, there are, as I said, each of
them offer an investment opportunity.

They have different risk
and return profiles.

And depending on the vehicle in which
you invest in them, uh, they could

have different degrees of liquidity.

Common equity in real estate
is typically not liquid at all.

You're, you're going to get your original
capital back in whatever return you're

entitled to, uh, when the property's sold.

Um, you may get some cash flow
distributions along the way, but in terms

of redeeming your interest or getting your
original principal back, that's really

going to require sale of the property.

Some of the debt funds do allow for
redemption and therefore the ability

to get your principal or part of
your principal back along the way.

But, uh, but the common
equity generally doesn't.

So

Brandon Giella: Interesting.

Okay.

So just to be clear on the preferred
equity side, you do get some of that

cashflow along the way, like you're
saying at a fixed rate, but then you're,

you're upside on a property that goes
really well is unlimited like equity.

So you get a little bit of a mix
of the debt, the, the, I guess the

outcomes or distributions or cash
flows of the debt plus equity.

Is that kind of how I'm

Paul Bennett: on the preferred equity
side, your returns usually fixed.

Um, it is not, you don't have,
um, unlimited upside or really

any upside, uh, preferred.

Debt of a preferred equity offering excuse
me would look like this the preferred

equity class Would would be entitled
to receive a total return of 12 percent

Brandon Giella: I

Paul Bennett: That return can be
paid partial part of it currently and

Part of it upon sale of the property,
but regardless of when it's paid.

You're never going to get more than a
12 percent annual return Uh, the common

equity is the slice of the capital stack
that has unlimited upside in terms of what

the ultimate value of the property is.

Um, PREF equity.

For example, in our transactions, which
we are development oriented, which

means there really is no operating
cash flow for a period of time, um,

in a development environment, the
pref equity is not probably going

to get any current return at all.

All of their return is going to come at
the end of the project when the project

is sold, because there is no cash flow.

You'd essentially be giving people
back their own money, right, if

you were paying any return at all
because it's, it's, You're just

paying them back their own money.

That doesn't make any sense.

I'll give you an example.

Um,

about six years ago, uh, I developed
an 80 million mixed use project just

outside Charlotte, North Carolina.

And, um, we had a substantial amount
of our equity in it, but we also

needed, um, some additional equity.

And we worked with a group,
um, out of Charlotte.

Happened to be Center Lane Capital, great
bunch of guys, and they put together an

offering, went to their investors and the,
the, the, and it was all preferred debt.

So they basically invested
$7 million in the project.

Um, because it was a development
project, there was no current

return on that $7 million.

But when the property was sold, they got
back their $7 million plus 14% per annum.

For the entire period, their money had
been invested, and once they received

that, they've now been paid out, and the
next funds that were distributed from

that sale were paid to the common equity.

I don't know if that helps clarify a

Brandon Giella: Yeah, yeah, yeah.

Yeah, no, that's super helpful.

Okay.

This is, this is some of those things
that, you know, I was a solid B student

and it just got a little confusing to me.

We're moving quickly through class.

So the way you're explaining it is
actually really, really helpful.

So help

Paul Bennett: it could be the student,
and sometimes it could be the teacher.

Maybe I'm not doing a
great job explaining it.

I had it really clear in my head
when we started all this, and,

um, But, yeah, I mean, everybody's
familiar with common equity,

everybody's familiar with senior debt.

The two pieces that they may not be
as familiar with are the preferred

equity and the mezzanine debt,
um, which are sort of hybrids.

Mezzanine debt is, is a second loan, so
again, different risk profile, different

interest rate because of the risk.

Preferred equity is equity.

But it doesn't have a lead on the
property, and it usually has a fixed

return, um, versus the common equity
that, that is the riskiest position,

but also has the most upside.

Hey, look, here's the reality
in investing in anything.

Risk and return are inextricably linked.

The higher the risk, the higher
return you should expect.

The lower the risk, the lower
the return you should expect.

And risk here is defined by the
ability to, to first get your original

capital back, and secondly, to get
the return that you started out

and invested for in the beginning.

Um, and senior debt, high probability
of getting your principal back,

high probability of getting
the return you were promised.

Mezzanine debt, slightly less probability
or, or slightly greater probability.

Lower probability of getting your
principal back and of getting your,

uh, of getting the return that you
were looking for, but, but certainly

a significant expectation that
both of those things will happen.

Preferred equity is a pretty
protected position as well.

Um, you're gonna, you know, you're, the,
the common equity that invested in the

deal can't get a dime of their original
principal or return until the preferred

equity has gotten all of its principal
back and whatever return they agreed to.

Um, so again, we kind of went to that
bottom up, senior debt to common equity,

but that's how they all relate to each
other and, uh, um, and, and, and therefore

how investors should think about them.

Um, at the end of the day, it's about
risk adjusted returns and is the

balance between the risk and the return
appropriate, um, and not distorted.

Brandon Giella: If you don't mind I
want to keep going with that train

of thought you just started because a
question that comes up hearing you You

listen to explain all this is is how
how should I if I were an investor?

How should I be thinking about what
kind of class or what kind of capital?

I would be thinking about
investing in a project.

Let's say there's a fund real estate fund.

That's got all four types Maybe some
wisdom or just some kind of decision

criteria that helps me understand where
do I want to fit in that capital stack.

I don't know if you have any
that come to mind, but that's

kind of where I go with that.

And then I also, if you don't mind,
just a few more minutes too, is,

um, why you guys chose just the
senior debt and the common equity.

And if you've looked, you know,
you mentioned looking at some of

the MES debt or preferred equity,
but why you ultimately stuck with

those two, maybe, maybe just a few
comments on both of those questions.

Paul Bennett: I think the first
question you ask is how, why would

somebody gravitate to one tranche
in the capital stack versus another?

It's first and foremost driven
by their investment objectives.

If you're an investor who's investing
for current income and you're at

a stage or place in life where
exposing your principal to any

significant risk is not advisable,
then you're a senior debt investor.

Um, because that is the tranche
in the capital stack that best

matches your investment objectives.

That would apply to somebody who's
approaching or in retirement, where

they don't have a lot of time to recover
from an investment that goes sideways.

Um, and at that stage of life,
they're typically looking

for current income, right?

Because they may be retired and
they're living off the investment

income they can generate.

Um, and so, it's really
driven by your investment.

The other thought you triggered when
you asked the question is, if you're

going to invest in any one of those
tranches, but we'll use senior debt

for now, what skill set is critical for
the sponsor that you're investing in?

And the answer to that, particularly
for senior and mezzanine debt, is

their ability to underwrite risk.

So, think about the process that you
went through when you bought a house.

They wanted your bank records.

They wanted your credit card statements.

They wanted, that's called underwriting.

They were, they wanted your credit score.

They were evaluating your
ability to repay that loan.

Commercial underwriting is no different.

They're looking at the
viability of the project.

They're looking at the
projections for the project.

They're looking at market data.

They're looking, as a lender,
they're looking at the sponsor and

his experience and his track record.

Um, and, and, so if you're investing
in a debt fund, whether it's mezzanine

or senior or some combination of
the two, they're basically acting

like a bank and making loans.

And so you want them to have a
You know, wide and deep expertise

in the underwriting of those
loans and identifying the risk.

Um, because you might underwrite the
right project, but offer too much debt.

Like, the project may be okay,
but if it's over levered.

So, not only the ability to
evaluate the project, but also

to evaluate how much debt.

should that project really get.

So anyway, I probably went too far there.

Um, but that's the other,
the other piece of it.

But it really is, you know,
again, a slide, I went inverse.

The, the first thing we talked about,
senior debt, has the least risk.

Common equity has the most risk.

Um, I would tell you in the corporate
finance world, there is a real possibility

um, that whatever stock you buy
could ultimately be worthless, right?

I mean, that, that's a real possibility.

A little less true in, in real
estate, because it's a tangible

asset, um, tends to never go to zero.

But, if there's leverage involved,
and the leverage is obviously in front

of you, it's not impossible in a real
estate transaction to wind up with a

common equity getting nothing back.

It doesn't happen very often,
but it's not impossible.

Brandon Giella: Yeah,

Paul Bennett: Um, and so you've
got different levels of risk, and

therefore different levels of return.

So, the, the investment objectives,
really are what makes sense.

You know, in your peak years, you're
probably more growth oriented.

Common equity offers the
best growth opportunity.

Um, those are the investors
that we have in our fund.

There are people that are looking
to grow their equity based.

They're not as concerned
about current income.

Um, and the way we leverage our projects
and because we're in an arena in self

storage and office industrial flex that It
has pretty consistent consumer demand, um,

you know, the common, when I say it has
the highest risk, that doesn't mean it's

overly risky, if that makes any sense.

But I can tell you this, we've
done a hundred, a hundred, over

a hundred, um, invest, we've made
over a hundred investments, ninety

of which have gone full cycle.

There's not one instance in which we
haven't at least given our investors

every dollar they gave us back.

We, we've had a couple of projects
that were in the single digit

return, so original principal
plus a 2, 3, 4, 5, 6 return.

Fortunately for us,
they're very, um, rare.

But we've never not been able
to, you know, give our investors

their principal back, so.

Brandon Giella: That's an amazing
statistic or factoid from your work.

I mean, you've been doing this for decades
and that that is the case after doing this

through, like you said, full cycle deals,
up market, down market, all of that.

That's amazing that you, you
are that successful in that way.

And obviously you can't, you know,
past performances not indicate future

results, but that you have that kind
of track record is truly incredible.

Paul Bennett: Well, uh, thank you.

Um, I think we're very proud of it.

Part of it is, you know, we, we've,
we're pretty good at what we do.

The other part of it is, we're in
a segment, even though we're in

development, Which is the riskiest part.

I guess if you kind of think about
the real estate industry in segments,

the riskiest play of all is raw land.

Right?

That's the riskiest play.

Um, the next is the vertical development.

If you're buying existing properties with
established cash flows, that's the least

risky play in the real estate world.

But within that development world,
that vertical development world, which

is where we sit, We're developing a
product that has historically been more

predictable than the other segments.

Self storage in Office Industrial Flex
has had just such consistent demand

over time that it's a little harder to
screw it up than it is developing an

office building or shopping center or,
you know, other types of multifamily,

um, where demand and, um, you know, ebbs
and flows dramatically in some markets.

So, anyway.

Brandon Giella: Yeah, it's really amazing.

Well, Paul, thank you so much.

I feel like I say this every episode,
but I love listening to your insight and

your expertise and also to listeners.

This is very valuable information
that I paid a lot of money for

in business school to understand.

So, Paul, you're, you're the
way that you're able to explain

it helps me understand so much.

So I hope that listeners are taking
notes and re listening to this

and thinking through it because it
is actually super, super helpful.

Paul Bennett: It's, it's
always fun, Brandon.

I love, I love what we do and I love,
you know, talking about it and I love

trying to help people understand it.

Uh, I feel like today I might
have fallen a little bit short.

I didn't, I didn't feel like I got
as clear for you as I'd like to,

but I hope, I hope it's beneficial
and I hope people enjoy it, so.

Brandon Giella: No, this is great.

Thank you so much, Paul.

Next episode, next week, we
may have a special guest on.

So I hope that listeners will stay
tuned for that and we will see you then.

Paul, thank you again so

Paul Bennett: Pretty excited, Brandon.

Take care.

Brandon Giella: All right.

See you.