Contrary to what the name suggests, structural risk has nothing to do with the physical structure of the building. Structural risk refers to the financial structure of the investment and the rights that the structure provides to the individual participants. No real estate investment is invulnerable to risk, and investors must understand the potential dangers.
Structural Risk Defined
In a standard investment, there’s a sponsor who finds, acquires, and oversees the operations and management of the property, there’s a lender who finances the property, and then there are equity investors. The sponsor is often referred to as the General Partner (GP), whereas the rest of the equity investors are Limited Partners (LPs).
When debt is involved, rankings are provided for repayment in the event of liquidation of the investment. For example, a senior secured loan is the first to receive a payout while equity holders are the last. Therefore, equity investors hold the highest level of risk.
Senior Debt vs. Subordinated Debt
The difference between a senior loan and a subordinated loan is repayment priority. In the event of bankruptcy or liquidation, senior debt is paid first. Once the senior debt is paid back in its entirety, subordinated debt may then be repaid.
Senior debt is typically secured, which is when debt is secured by collateral (i.e., real estate). When a company files for bankruptcy, the issuers of senior debt are the most likely to be repaid with junior debt holders, preferred stockholders, and common stockholders being secondary. With subordinated debt, there’s the risk that the company will not be able to repay that debt if all money goes towards senior debt during liquidation.
A joint venture is a business arrangement where two or more parties agree to pool resources to develop a new real estate project or investment. Despite working together, each participant in a joint venture maintains their own business identity. When a joint venture is formed, there’s typically a legal agreement that specifies each participant’s contributions, responsibilities, and how profits will be distributed.
One of the most popular structures for a real estate joint venture is a limited liability company (LLC). Other structures include corporations and partnerships. There’s structural risk relative to your position in the joint venture arrangement. This dictates the amount paid to the sponsor when the investment property is sold. Depending on the amount paid to the sponsor, gross profits will be diminished.
Alignment of Interest Between the Sponsor and the Investor
You must consider the alignment of interest between the sponsor and investor. How much equity is being invested by the LLC compared to the sponsor? For example, if you are a limited partner with a favorable profit split where the sponsor has less invested or less equity in the deal, they are motivated to take more risk.
There’s structural risk with any investment. Investors need to understand structural risk and how it can impact their rights associated with the financial structure of the deal. The best way to minimize this risk is to set yourself up advantageously in the deal.