A new capital structure for affordable housing
There are many complex reasons why this country is in such dire need of affordable housing. The fact that conventional equity investment structures in real estate are directly at odds with tenants’ needs to have predictable and appropriately priced housing costs is one that gets little attention. How can apartment owners keep rental rates in their communities relatively “stable” to meet the economic needs of their residents when equity investors in these assets demand returns on their investments (over periods of investment relatively short) that can only be satisfied if landlords push rental rates as high as possible?
Recently, my colleagues and I worked with a group of impact investors and an impact entrepreneur to design, build and document a new investment structure that we call “Performance Aligned Equity” (PAE). We designed PAE to create a vehicle for early stage investments in impact businesses that, among other things, enables investors to achieve a rate of return on and from their investments that is aligned with the revenue stream of the business; and allows company founders to retain control of the company and safeguard its impact mission.
PAE, in short, is a venture capital investment structure that better aligns the needs and missions of impact companies with the goals of the venture capitalists from whom they receive the necessary equity.
The EAP is an equity investment that acts like debt, but with redemptions rather than repayments. Similar to the interest payments required for a loan, investors receive a stated and predictable rate of return on their investments based on a set schedule and a fixed “dividend pool” funded by operating cash flow of the beneficiary company. The timing of the establishment of the dividend pool and the first dividend distributions, as well as the amount of each distribution, can be customized to meet specific business needs and cash flow projections. With each scheduled payment of “dividends” from the pool, investors receive both a declared return on their investments and a return on a portion of their investment through mandatory partial redemptions of their shares.
The EAP can be structured to give investors the right to participate in the management of the business, through a seat on the board of directors or some other mechanism, but only so long as they retain a specified percentage of ownership of the business. This percentage will automatically decrease as scheduled redemptions of their investments occur. Investors may separately be granted continuing rights to participate in certain material decisions that could adversely affect their investments.
In practice, these rights could be triggered when the admission of additional investors of the same category would have a dilutive effect. However, with PAE, investors have no right to force a sale, recapitalization or refinancing of their investments, or any other form of exit by the impact company, keeping the founders under the control of the impact business and preserving the impact mission of the business.
PAE investments would be relatively easy to structure for rental property owners and developers, since these communities’ cash flow projections (i.e. the revenues that underpin the PAE base rate of return and associated repayment terms) are regularly calculated and reliably used for traditional real estate. private equity transactions.
Here are some circumstances where EAP investments might be helpful:
- To fill a gap in the capital stack for an acquisition or grassroots development transaction.
- To attract new types of equity investors, such as impact investors interested in supporting affordable housing and the workforce, banks seeking to deploy Community Reinvestment Act funds in innovative ways, and foundations organizations focused on deploying program-related investments that advance their housing-related missions.
- To fund current or deferred capital expenditures needed for apartment communities without incurring additional debt or increasing rents.
- To fund the capital needed to build additional units in an existing apartment community that has developable land.
- To cover unexpected operating deficits and otherwise assist owners in the event of unexpected cash flow disruptions (such as those caused by pandemics).
- If included as a component of a sponsor’s or owner’s required capital contribution to a transaction, the EAP may allow that sponsor or owner to retain a greater percentage of ownership of a community, as the EAP is redeemed over time, keeping the price affordable for a longer period.
- Although this would require more evaluation and likely additional iterations of the EAP structure (and introduce additional securities laws and other legal considerations), the EAP could be used as a vehicle to allow residents to a community to invest in the community and earn a return on investment. and on their invested capital, creating a meaningful way for these residents to feel ownership of the communities in which they reside.
Pam Rothenberg is a partner in the Washington, DC office of Womble Bond Dickinson (US) LLP, practicing in commercial real estate, business and entrepreneurship. She founded and leads Womble’s Impact Business Group, the first integrated multidisciplinary impact offering established by a US law firm.