Everything You Need to Know About the Capital Stack

When it comes to capital stack in real estate, there are four main components. Here’s what you need to know to build portfolio profits.

Introduction

The capital stack is one of the most important concepts for investors interested in evaluating real estate risk and projected rate of return.  Understanding the capital stack to assess tradeoffs can protect your investment from undue risk, or insufficient gains. There are many ways to evaluate a potential investment in a commercial real estate deal, and the capital stack is among the most valuable – it lets you know who gets paid, in what order, and how much risk they carry. Each are incredibly important when it comes to determining the risk and reward of a given investment.

In simple terms, the capital stack represents the underlying financial structure of a commercial real estate deal. Often, the capital stack is presented as a graphic that shows the different types of capital in a deal stacked above each other, like a cake with many layers.

The two main components of the capital stack are debt and equity. Both debt and equity also have subdivisions of their own, with different types of debt and equity available for use by investors, aka common and preferred equity and mezzanine and senior debt. We’ll get into in more detail a little later.

What is the Capital Stack in Real Estate?

The capital stack refers to the layers of capital that go into purchasing and operating a commercial real estate investment. It outlines who will receive income and profits generated by the property and in what order. The capital stack also defines who has the first right to foreclose on the asset as collateral in the event the equity owner defaults on the mortgage.

The capital stack is typically comprised of four sections in the following order: common equity, preferred equity, mezzanine debt, and senior debt. Although common equity is listed first in the stack, it holds the lowest priority, meaning common equity lenders are paid last. Senior debt, at the bottom of the capital stack, holds the strongest priority, meaning senior debt lenders are the first to be paid.

While each investment level comes with its own risk and reward, the higher positions in the capital stack typically earn higher returns as a result of their higher levels of risk. Here is a very simple example of capital stack:

Let’s say you purchase a property for $1,000,000. You put down 20% and finance the rest. Here is what the capital stack would look like:

TYPE OF CAPITAL AMOUNT PERCENTAGE
Equity (down payment) $200,000 20%
Debt (mortgage) $800,000 80%
Total $1,000,000 100%

In this simple example, when the property is sold, the bank is paid first out of proceeds from the sale, and the equity is paid last.  In the event the sales proceeds did not total $1,000,000, the bank is still paid first and the equity would be paid whatever is left for distribution.  In the event that the sale proceeds are inadequate to pay the bank, the equity position would be wiped out and the bank may seek to recover its entire position by pursuing other collateral originally provided by the borrower, including a potential personal guarantee.

Order of Priority Within the Capital Stack

The four types of capital are typically listed from lowest priority to highest priority with common equity and preferred equity listed first (at the top), and mezzanine debt and senior debt listed third and fourth, respectively. If a property doesn’t generate enough of a return to pay all investors or debtors, the property’s income is distributed from the bottom up, starting with senior debt and then mezzanine debt. Any money left would then flow up through the preferred equity and common equity positions.

Investors who are risk averse will most likely want to invest in the lower portion of the stack, which has lower returns and lower risk. Those who are comfortable with higher levels of risk and want a higher return will want to focus on the top of the capital stack.

Here is a summary of some of the highlights to keep in mind when looking at the capital structure in any deal:

  • Capital stacks prioritize different capital types by seniority, with the least senior on the top and the most senior on the bottom. Equity positions are registered first, with debt positions below.
  • When it comes to properties that are unable to generate enough cash to pay all investors or lenders, capital listed on the bottom of the stack will be paid first and any leftover cash then flows to the capital that holds the next lowest position.
  • Should issues arise and the property goes into default, claims to assets are processed in order of seniority in the capital stack with the lower placed capital retaining foreclosure rights superior to those higher up in the stack.
  • In most cases, higher risk capital sits at the top of the stack, while lower-risk sit below, and the lowest at the bottom. In a similar vein, higher return potential typically sits at the top of the capital stack, with expected returns that decrease as you go down the stack.

The capital stack and its components are the backbone of any deal. They drive the financing and profitability of a project, and the right capital stack components can make or break a project.

A common risk for many real estate investors is to increase the debt portion of their capital stack to increase leverage.  This does create an amplification effect on returns by reducing the amount of equity required relative to projected profits, but it can also expose a project to excessive risk of foreclosure in the event debt cannot be serviced. At the same time, under leveraging a project can also mean leaving money on the table. Finding the optimal balance between debt and equity and the integration of the right levels of preferred equity and mezzanine debt is dependent on advanced underwriting and years of experience.

The 4 Layers of Capital in Capital Stack Funding

Most types of capital in the stack can be grouped into one of these four categories: senior debt, mezzanine debt, preferred equity, and common equity.

1.  Senior Debt:

Senior debt holds priority over all other positions in the capital stack. In other words, senior debt lenders are to be paid before any other investor is given a return on its investment. The senior debt in capital stack typically refers to the mortgage lender or some other debt holder who has the highest claim on the underlying asset. This is the least risky position to be in because, if the borrower fails to make the mortgage payments, the lender can take over the property ownership through a foreclosure action and sell the property to recover the amount owed.

If an investor is trying to understand the risk involved in a commercial real estate investment, among other things, they should look at the loan-to-value ratio (LTV). The LTV is the amount of debt on a property relative to its overall value. If the loan has 65 percent LTV, there is a lot more room for error than an 85 percent LTV loan because, as the lender, you would much rather end up owning the property at 65 percent of its value than at 85 percent, if forced to foreclose, in order to recover the capital loaned.

Senior debt typically comprises 75 percent of the total project cost though this can vary depending on the risk profile of a building, the stage of a cycle, and the creditworthiness of the borrower, among other factors. It is the best secured position in the capital stack because it retains the property itself as collateral. The tradeoff is that the senior debt typically receives the lowest return of any other position in the stack.

2.  Mezzanine Debt:

After all operating expenses and the senior debt payment have been made, any excess cash will go to servicing the mezzanine debt. For that reason, it is second to senior debt in order of payment priority and in its position in the capital stack. A second mortgage on a home, or a HELOC, is similar in nature to commercial mezzanine debt.  Because of its secondary nature, mezzanine debt will usually have a higher rate of return than senior debt – similar to why home equity debt typically comes with a higher interest rate than that of a primary mortgage.

3.  Preferred Equity:

Preferred equity is a somewhat vague term in the capital stack because it has come to take on different characteristics in recent years. Historically, the term was used to describe a type of capital that works similarly to common equity but has superior payment rights. However, since the Global Financial Crisis, it has morphed to function like subordinate debt and receives a fixed return without any share of profits, but with enhanced rights to take over a project in the event of default.

This evolution stems from a realization by lenders during the Global Financial Crisis that mezzanine lenders had greater rights than expected which complicated first position lien holders’ recovery efforts when borrowers defaulted.  To prevent this from happening again, lenders increasingly prohibited the use of second position loans, including mezzanine debt. To replace it, preferred equity was restructured to fill the same gap in the capital stack, but designed not to look like (or be called) debt, but to function as close as possibly to debt as first mortgage lender requirements would allow.

4.  Common Equity 

Lenders typically require developers or sponsors to contribute some of their own money into an investment via common equity – colloquially known as ‘having skin in the game.’ Common equity is provided by the individuals who operate the property on a day to day basis, the sponsor or operator, and their investor partners, and is the riskiest yet potentially most profitable portion of the capital stack.

Common equity holders get paid after all other parts of the capital stack and preferred equity investors have received their agreed-upon returns, making common equity holders last in priority. Although not guaranteed, common equity holders are entitled to recurring payments from the property’s cash flow after all other capital holders have been paid.  This is typically paid in the form of a preferred return on their investment which is paid for out of available cash flow once all other creditors loan servicing has been made. In addition, common equity holders participate in property cash flow distributions, if any. If the property does well, equity investors typically do not have a cap on their return potential.

How does investing with Feldman Equities fit into your overall investment goals?

I’m always looking for investment, which is passive, so that I can scale and looking for a good combination of dividend and equity. I don’t normally invest in, what I would say, speculative kind of investment, you know, you’re building from scratch. Even though there’s higher potential, I don’t feel comfortable investing in those things. And that might be my personal decision. So, it’s really focusing on core or core plus and the rest of the thing is really looking at the sponsor. I’m more, because of the COVID, I’m a little bit, putting a pause, right now, just to understand what is the impact on real estate.  But, if this had not happened, you know, I probably would have continued the pact, you know, again, this is also a learning experience, right, something that you didn’t expect and could happen, right? So that’s why diversification is important, you know. So right now, really taking, in fact, I was looking at everything and said, OK, if I had to plan from scratch, what would I do, given the situation right now, I am in. You know, given the current situation, given that I have kids in the college. How would I diversify so that I’m not taking unnecessary excessive risk? I think that’s probably the most important thing.

An Example of a Capital Stack

The graph below shows what a capital stack looks like on paper. Note how the highest priority position sits on the bottom, with priority decreasing as you move up the stack. In first position you see bank debt with the lowest risk, and the lowest interest rates. Above that sits second position bank debt, which is still relatively secure to the capital above, but does carry higher risk than the bottom of the stack.

If you look directly above the mezzanine debt you’ll see the preferred equity we discussed earlier, with the highest interest rates, highest risk profile and typically no profit sharing. Finally, you get to your investment at the top, the preferred return, which carries the highest risk but offers the expectation of long-term growth and profit.  Remember that a capital stack is not limited to four layers, this graph just shows a common example in the commercial real estate industry.

Here’s an example of a capital stack you might see in a commercial real estate investment to buy and renovate a property for a purchase price of $8 million and a total cost of $10 million:

CAPITAL TYPEAMOUNT% OF TOTAL
Common equity$2,000,00020%
Preferred equity$1,000,00010%
Mezzanine debt$2,000,00020%
Senior debt$5,000,00050%
Total$10,000,000100%

Here’s a way to break this down:

Most commercial real estate deals typically have a sponsor, which is the person or company responsible for finding, acquiring, and managing the property on behalf of the overall partnership. The sponsor is also typically expected to invest between 5 and 10 percent of the required equity capital. So, to break this down, let’s say the deal’s sponsor contributes $200,000 in equity capital and raises an additional $1.8 million from common equity investors. The sponsor might also borrow $5 million from the bank for the purchase, with that loan secured by the property itself. Additionally, the sponsor may obtain a bank loan for $2 million to finance the property’s renovations, which would also be in a subordinate position to the purchase loan, and finally they may also raise preferred equity in an amount of $1 million from a debt fund or equivalent.

Why the Capital Stack is Important

A commercial real estate investment’s capital stack is arguably one of the most important concepts an investor needs to analyze the equity, debt, and risk return profile of a project. Ultimately, as with any investment, commercial real estate comes with downside risk. Investors who understand the capital stack can assess risk and repayment, where they fall in the pecking order of cash flows, and whether or not that investment is worth the assumed risk.

The capital stack is also important because it provides an overview of the claims that every investor has in the asset – a hierarchy of power, if you will, over who can ultimately take ownership of the property in the even the borrower defaults on payments. The senior debt owner holds a claim in the form of collateral in the building for the amount of the loan that is owed to them, referred to as the principal including any interest payments, fees and penalties that might accrue. They retain the right to take ownership of the property away from the borrower in the event the borrower defaults on their payment obligations. Mezzanine lenders have a right to step into the equity holders’ shoes in the event the borrower defaults on the mezzanine payments but not the first mortgage. In that case, the mezzanine lender would become the equity holder and would be required to continue payments to the senior mortgage lender.  Equity holders generally do not have foreclosure rights to a property and so stand to lose their equity completely in the event the sponsor defaults on loan payments to a lender higher up the capital stack.

Prior to investing in commercial real estate, investors should always carefully analyze the capital stack to determine the level of risk. For example, if there is a high percentage of debt in the capital structure, this will mean greater financing costs and consequently a higher risk of default by the borrower should economic circumstances deteriorate. It is often better to invest in real estate assets that have an equity-heavy capital structure, as there is less chance of defaulting on a mortgage and, therefore, lower risk.  A zero-debt investment has zero risk of loss to a lender because, by definition, there isn’t one.

Attributes of an Equity Investment that Could Impact the Attendant Risk and Potential Upside

As with any investment, there are various factors that impact both risk and upside in a real estate investment. Here are some of the common factors that investors should keep in mind:

  • Strong, established market: the local economy plays a critical role in impacting attendant risk and potential upside for a commercial real estate investment. When determining where to invest, it is best to analyze the level of demand and competition in the market. If the asset is an apartment complex, how are other apartment complexes performing? Do they have high vacancies or strong demand?
  • Stable cash flow: reviewing the rent rolls of a commercial real estate property can help an investor understand the approximate cash flow of the asset and project with varying degrees of confidence how sustainable that cash flow may be over the long run.
  • Limited development plans: if extensive, complex capital improvements are needed, there is higher potential for lengthy delays and vacancies. The longer the development plans are in place, the more income the property forgoes while the improvements are implemented.
  • Business Strategy: Equity investments differ wildly in their risk/return profiles due to differences in business strategies. Things like the project’s complexity, potential/current cash flow, lease-up numbers and rent rolls will affect the risk/return potential of any given CRE investment. Make no mistake, operating a commercial property is a full-time endeavor, which becomes more complex and challenging as you scale up. Having a seasoned sponsor developing and executing on a well-considered business plan is an important component in mitigating risk.
  • Location and Market: It’s no secret that location has a big impact on the success or failure of a commercial real estate project. For instance, your risks will be lower in a market like Tampa, due to the attractive climate, diverse employment base, and other positive attributes that make the area desirable for employers and employees alike. Conversely, in areas with less demand you may face less competition, and potentially higher returns, but you will be more liable to be affected by market shocks and downturns.

Conclusion

With every real estate investment, some combination of common equity, preferred equity, mezzanine debt and senior debt almost always come together to create the capital stack. Understanding where the investor sits in the capital stack helps assess the level of risk they are exposed to at the hands of other participants in the stack. Before investing in any deal, a prudent investor will look to see the extent to which lenders, who retain the property as collateral, are involved, and how other equity holders relative returns compare.

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