The capital stack is an important concept for investors to understand to properly evaluate real estate investment risk and the projected rate of return. Understanding a deal’s capital structure allows investors to weigh the potential tradeoffs and protect from any unwanted risks.
While there are multiple ways to evaluate a potential commercial real estate investment, the capital stack is considered by many to be one of the most valuable. It lets you know who gets paid, in what order, and how much risk each carries. All of these are important factors to consider when determining the risk and reward of an investment.
A typical commercial real estate asset is often quite expensive, which means most investors do not have the resources to purchase it with their own capital. This might seem like a negative, but it is actually an opportunity. One of the major benefits of commercial real estate investment is the wide availability of debt financing for investors, often at favorable terms. This debt only makes up about 60%-80% of a property’s purchase price, though. The rest of the money must come from a combination of other sources. These different sources of income combine to create the capital stack.
In the simplest terms, it is a representation of the underlying financial structure of a commercial real estate deal. Often, it is presented as a graphic, with the different types of financing in a deal stacked above each other like a layered cake.
The two main parts of the capital stack are debt and equity. Both have subdivisions of their own, with different types of each available for use by investors. This refers to common vs. preferred equity and mezzanine vs. senior debt.
In theory, though very rarely, commercial real estate is purchased using 100% equity. Usually, however, most sponsors take on some degree of leverage when acquiring a commercial asset. This leverage can help amplify returns for investors. It also becomes part of the structure, along with other forms of debt and equity.
More specifically, the capital stack refers to the layers of financing that go into purchasing, and later operating, a commercial real estate investment. In real estate especially, it defines who has the right to the income and profits generated by the property throughout the hold period and upon sale. Even more importantly, it determines who has the rights to the actual asset in the unfortunate case of a default.
There may be more or less debt vs. equity depending on the asset, and the types of debt and equity can vary from asset to asset. It also depends on how risk-averse an investor is, meaning two investors may look at the exact same deal and still approach the capital stack differently.
No matter how an investor chooses to invest in an asset, whether it be through an online marketplace or other platform, the capital structure is worth understanding for any given transaction, along with the risks and rewards associated with each separate piece of the stack. Understanding the position of an investment in the stack makes up a crucial part of due diligence because it helps quantify both the potential benefits and potential risks.
The four types of capital are typically listed from lowest to highest priority, putting common and preferred equity at the top, and mezzanine and senior debt at the bottom of the stack. If a property fails to generate enough of a return to pay all the investors or debtors, the property’s income is distributed from the bottom up, beginning with senior debt and followed by mezzanine debt. Any money left then makes it to preferred equity, and finally, common equity.
Capital stacks prioritize different types by seniority, but also what happens in the case of default. A common risk many commercial real estate investors face is increasing the debt portion of their stack to increase their leverage. While it does amplify potential returns, it may expose an asset to excessive risk of foreclosure in the event the debt cannot be paid.
On the other side, under-leveraging a project can mean leaving potential profits on the table. The key is to find the right balance between both.
Most types of financing fall under one of these four categories: senior debt, mezzanine debt, preferred equity, and common equity.
Senior Debt: Senior debt holds priority over all other positions in the capital stack. Typically, it refers to the mortgage lender or other debt holder. This means the senior debt lenders are paid before any other investor is given a return on the investment. Of all the positions, this tends to be the least risky because if the borrower fails to make their mortgage payments, the lender can take over the property’s ownership through foreclosure actions. They can also sell the property to recover the amount owed.
If an investor wants to understand the risk involved in a commercial real estate investment, they should look at the loan-to-value ratio, or LTV. This is the amount of debt on a property relative to its overall value. For example, if the loan has a 65% LTV, there is more room for error than an 85% LTV loan. As a lender, you would much rather end up owning the property at 65% of its value than 85% if forced to foreclose, in order to recover the capital loaned.
Senior debt typically makes up 75% of the total project cost, though this can vary depending on the risk profile of an asset, the stage of the market cycle, and the creditworthiness of the borrower, among other factors. It is the best secured position because it retains the property itself as collateral. The tradeoff is that senior debt typically receives the lowest return of any other position in the stack.
Mezzanine Debt: After all operating expenses and the senior debt payment are made, any excess cash goes to servicing the mezzanine debt. It is second to senior debt in order of payment priority and position in the capital stack.
Mezzanine debt fills the gap between the amount of debt the senior lender is willing to provide and the amount of money raised through equity. It may also be called subordinate debt, sub-debt, junior debt, or a second mortgage.
While the senior debt is secured by the property, mezzanine debt can be either secured or unsecured. Mezzanine debt, from a lender’s perspective, might be considered safer when secured by the property, but a deal with significant senior debt gives the senior lender first priority, which puts the value of this secured mezzanine debt in question. Most borrowers prefer to have unsecured mezzanine debt because secured debt is often viewed as a liability.
Because mezzanine debt is repaid after senior debt, it carries a slightly higher risk profile and usually a higher interest rate. These higher rates and risks encourage many real estate investors to see to maximize the amount of senior debt they get before using mezzanine debt.
This type of debt is usually provided by investors who are comfortable with owning and operating real estate. After the senior lender is repaid first, the mezzanine lender may have no other choice but to take back the asset or the management of the asset in order to recover their losses. Typically, the senior debt and mezzanine lenders enter into an agreement, called an intercreditor agreement, where they determine how their rights over an asset interact.
Preferred Equity: In most commercial real estate transactions, a single-purpose entity is created to be the purchasing vehicle for the investment property. Where senior and mezzanine debt are secured by an interest in the property itself, preferred equity is secured through an interest in the property’s ownership entity. It is usually third in the stack, near the top.
Preferred equity has evolved over recent years. Historically, the term meant a type of capital that works similarly to common equity but has superior payment rights. Following the financial crisis of 2007 and 2008, it morphed to function a bit more 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 a default. Despite this, it is not considered a debt, but structured as an investment in the entity; whether it be an LLC, trust, or something else overseeing the deal.
There is also a difference between “hard” and “soft” preferred equity. Hard preferred equity is functions similarly to mezzanine debt. Soft preferred equity functions similarly but is more likely to include some financial upside if the project performs well. Soft preferred equity holders also usually have more limited rights than hard equity holders.
In general, preferred equity and mezzanine debt are used for the same purposes. A sponsor seeks either one when they are unable to secure sufficient senior debt. In practice, most investors will use either mezzanine debt or preferred equity. Rarely will deals include both.
Common Equity: Lenders typically require investors to contribute some of their own money into an investment via common equity. This is provided by the individuals who operate the property on a day-to-day basis, whether that is the investor or a property manager, and they’re investing partners. These holders are individuals who purchase shares in the property’s ownership entity, though their interest is subordinate to preferred equity investors. This is the riskiest, yet potentially most profitable portion of the capital stack. If a property is sold for more than its purchase price, they have a chance of earning a higher return than other members in the structure.
Because they hold the lowest priority position within the structure, near the top, common equity investors might see no return on investment if something goes wrong. Included in this layer are private equity firms, REITs, pension funds and individuals.
There are many different factors that can influence the potential profit of their investment opportunity, including capitalization rates, market cycles, and the overall business plan for acquiring and managing the asset.
Though there are four components of the capital stack, the reality is that it is rare to see all four forms of funding being used. Many commercial real estate transactions are financed with a combination of senior debt and common equity. Mezzanine debt and preferred equity raise the overall risk profile of a transaction and may complicate administration of the investment, which makes them less popular except in last resort.
The capital stack is important for two reasons. From a sponsor’s perspective, how the stack is structured will influence a deal’s overall profitability. For example, a highly levered asset that performs well would generate higher returns for equity investors. Meanwhile, an otherwise enticing investment may be ruined with the wrong combination of debt and equity.
From an investor’s perspective, understanding the stack is especially important, particularly as an investor tries to determine where to invest. Investors looking for safer investments at lower yields might want to invest in low-leverage debt compared to those who are looking for higher yields and choose to invest in common equity. Having the knowledge to understand the type of capital used can benefit investors when determining how likely they are to be repaid in both favorable and unfavorable scenarios.
For a more in-depth example, consider this fictional deal that demonstrates how the capital stack affects payouts. A commercial real estate firm chooses to purchase a multifamily property with promising investment opportunities. The cost of the property is $1 million, so to finance the property, they obtain a bank loan of $750,000 and sell shares for their own firm to raise the remaining $250,000.
In this scenario, the bank represents the senior debt or lender and the investors who purchased shares in the firm represent the common equity holders. This means the rental income from the property is used in the following order: pay the property’s operating expenses, pay the property’s loan payments, and then distribute excess capital to equity investors.
In the worst-case scenario, a recession strikes and a high percentage of the property’s tenants are unable to make their rent payments. This leads to there being less available income to pay the loan payments, so the borrower (the firm) defaults. In order to protect their investment, the senior lender (the bank) forecloses on the property and takes possession of it. Since they are not in the real estate business, the bank immediately puts up the property for sale, but current economic conditions mean they are only able to sell it at a loss for $800,000. This is where the rights and priority order of a capital stack become most important.
Assuming that at the time of foreclosure the senior loan still has a balance of $750,000, the senior lender is entitled to $750,000 of the sale proceeds. This will be used to satisfy the loan’s outstanding balance, and the senior lender is now paid in full. The remaining $50,000 will then go to the common equity holders. Because the $50,000 is less than the initial $250,000 invested, these investors will only receive a fraction of their initial investment back.
This might seem a bit scary to any investors new to common equity, but these investors would benefit from considering the flipside as well. Assuming the same situation, but using the best-case scenario, everything with the property goes well. For five years, the property operates as predicted, rents go up, and it is sold for $1,250,000 with $600,000 balance remaining on the loan. Sale proceeds would go toward the loan and pay off the remaining balance, with the other $650,000 going to common equity holders, earning them a profit of 2.6x their original investment.
The point of these two scenarios is to demonstrate that all commercial real estate investments involve some risk. What matters is an investor’s relationship to that risk and whether they are willing to take on that risk in return for potentially higher returns. By understanding how the capital stack is structured, an investor may better determine whether an investment opportunity is worth investing in, rather than passing on something potentially profitable.
Understanding the different investment structures across the capital stack is important for any investor considering making commercial real estate a part of their portfolio. Much like investing in stocks and bonds, how you divide your portfolio between equity and debt real estate investments is largely dependent on your investment goals and strategy, including your risk tolerance.
For risk-tolerant investors, equity may be more appealing, while risk-averse investors may find the relative security of debt more appealing. As with any investment, take the time to learn more about the potential opportunities and risks before making a final decision.
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