A single commercial property may appear as one investment, but it is very common for its funding to come from multiple sources. Different sources have different pricing/risk and ranking as well. These layers together make up the capital stack.
Anyone who uses this guide to capitalize on capital stack real estate will improve their deals, limit risk exposure, and select financing that works for their long-term returns.
What is a Capital Stack?
The capital stack describes how a real estate project is funded. It also tells you who puts money in and gets paid first when the property makes money or is sold.
The main layers include:
- Senior debt
- Mezzanine debt
- Preferred equity
- Common equity
The lower a layer in the stack, the riskier that these layers are. But, with that extra risk comes higher potential return for riskier investors.
The Four Main Layers
Senior Debt
Bank lending or commercial lending is normally senior debt. It gets first dibs on what property generates income, as well as proceeds from sale.
Since this position entails less risk, senior debt typically carries the lowest cost of capital. It may include:
- Traditional commercial mortgages
- Construction loans
- Bridge loans
- Agency or government-backed financing
The senior lender is an investor who gets paid ahead of any other capital provider in the event that the borrower defaults.
Mezzanine Debt
Mezzanine debt makes up the difference between senior financing and the full cost required for the project. It could also be backed by a second lien or equity stake in the borrowing entity.
Such financing can dampen the share of cash put into investors. But, the lender will generally charge a higher interest with more risk on their part.
Preferred Equity
Preferred equity is not a standard loan. The investor receives a preferred return before common equity holders receive distributions instead.
This layer may come in useful when a project needs more funding but the sponsor does not want to increase its indebtedness. Investors may also enjoy so-called consent rights or other protections.
Common Equity
The most subordinate layer is common equity. It generally comes from the property sponsor, partners or outside investors.
Only after the lenders and preferred investors have been repaid, do common equity holders receive anything. This is a risky position to be in, as their returns are tied to how the property performs.
Why the Capital Stack Matters?
The capital stack real estate structure is an important aspect that can be carefully plotted to improve a project’s financial flexibility. It may help investors:
Nonetheless, the more layers you create, the more expensive and problematic repayment obligations can be.
Review the Entire Structure
In practice, before making an investment you should analyze the interest rates, repayment priority, maturity dates, ownership rights, and target return for each layer.
Not all capital stacks are created equal, and the stack with the most funding isn’t always the strongest. The one that is best fitted with the earnings of the property, level of investment risk, and time horizon. Capital stack real estate enables investors to make informed decisions without the shock of a market shift.
