Understanding the Ins and Outs of Real Estate Capital Stack

Office building divided into vertical sections showing the real estate capital stack from least risky debt to most risky equity title text is "Understanding the Ins and Outs of Real Estate Capital Stack”

Understanding the Ins and Outs of Real Estate Capital Stack

Office building divided into vertical sections showing the real estate capital stack from least risky debt to most risky equity title text is "Understanding the Ins and Outs of Real Estate Capital Stack”

Almost all commercial real estate deals are financed with some combination of debt and equity. Multiple lenders and equity investors could potentially patriciate in a real estate investment, depending on the size and scale of the operation. Capital stack just refers to the types of debt and equity capital used to finance a real estate deal, as well as the order in which each contributing lender or investor will be repaid and earn their share of the profits.

Anyone considering an investment in commercial real estate will want to understand the structure of a capital stack. For instance, a sponsor that offers investors common equity in a deal will want to know that they will be repaid last, behind both those that offer debt and preferred equity. Although, this hierarchy is not necessarily bad; the lower you are in the capital stack, the more you could earn from the return on your investment. In any case, understanding the factors that influence a capital stack is key to any investor’s educational experience.

Here, we focus on the importance of the capital stack and the different levels involving the structure.

Related: Essential Business Retail Real Estate Investing

What is The Capital Stack?

Capital stack is the structure of all debt and equity used to finance a commercial real estate deal. There are four main levels of the capital stack: senior debt, mezzanine debt, preferred equity and common equity—ordered from highest to lowest repayment priority, also known as the “distribution waterfall.” Though, the further down your placement in the capital stack, the sooner you earn your profits in the distribution waterfall.

The capital stack also accounts for the risk-return ratio of a property investment in its positioning. Investments (debt) are usually considered the lowest risk at the bottom of the capital stack because they are the first to be repaid from the real estate’s cash flow, sales, or other profits. Since equities at the top of the stack are considered the highest risk, they are repaid last.

Before investing in a commercial real estate deal or fund, investors should understand where they lie in the hierarchy of the capital stack to measure the potential risks and rewards of pursuing the deal.

What Are The Different Positions Within a Capital Stack

Senior Debt

Senior debt sits at the bottom of the capital stack as the least risky position. It is the first to be repaid from profits, or in the event of a default or bankruptcy. Senior debt appeals to investors who want the least amount of risk when investing, typically through a fund or other mechanism of combined capital.

Senior debt is usually established with a mortgage or deed to the property, serving as collateral for the loan. The lender’s loan-to-value threshold (LTV) is assessed to base the senior debt off of. For instance, a traditional bank may only offer a 60% LTV loan—possibly due to a substantial loan ($10+ millions)—considering the deal’s size and scale. In this case, the lender takes a calculated risk that the property could sell for at least 60% of its present-day value in the event of default, meaning the loan would be repaid in full.

Since senior debt has a lower risk profile, it usually has the lowest interest rates, too. Lenders can repay senior debt in many ways, including paying only interest for a set period or amortizing over a period much longer than the loan’s term. This kind of structure allows lenders to make lower payments during the loan term with a balloon payment due at the end.

Mezzanine Debt

Mezzanine debt, or “junior debt,” is the second lowest in the capital stack hierarchy, sitting above senior debt and below and the equity levels. This means that mezzanine debt gets repaid after the senior debt but before equity. Unlike senior debt that traditional bank lenders usually finance, mezzanine debt is typically financed by investors or third-party lenders (i.e., hard money lenders). Borrowers may use short-term bridge loans as mezzanine debt, too. Bridge loans provide the capital needed between senior debt and equity offered.

Mezzanine debts have higher rates of return for their investors because they usually come with higher interest rates compared to traditional senior debt.

Mezzanine debt is often utilized when a traditional lender only provides 60–70% loan-to-value for a commercial real estate deal. The investing sponsor may only be able to come up with 20–25% equity for the deal, which means the mezzanine debt would provide the capital needed to close the deal. Mezzanine debt generally consists of only 10–20% of the total capital stack.

Mezzanine debt also allows investors to increase returns for equity investors because there is more leverage for the deal, which translates to better returns on equity for investors (theoretically).

If a property were to default, the mezzanine lender has no direct rights to the property because a lien on the borrower secures the senior debt. Instead, the mezzanine debt lender will receive the borrower’s interest in the legal entity that owns the property. In the event of default, the mezzanine lender will then assume the borrower’s equity in the property then usually negotiate with the senior debt lender to fix any existing defaults.

Preferred Equity

Preferred equity is essentially another form of leverage for the sponsor, providing the capital needed for the real estate deal that the sponsor cannot obtain through conventional debt channels.

Preferred equity sits above all forms of debt as the first type of equity in the capital stack. It is repaid only after the senior and mezzanine debts have been repaid. But, if there is no mezzanine debt, preferred equity will be junior repaid second to senior debt and hold priority over other equity investor profits or distributions.

An example: a real estate project is worth $40 million with $25 million in senior debt, $5 million in mezzanine debt, $2 million in preferred equity and $8 million in common equity. The deal could potentially lose 20% of its value ($8 million) but the preferred equity would still be fully repaid; however, the common equity is lost.

Institutional investors are attracted to preferred equity investments because they receive larger returns than the debt providers but also take on less risk than common equity investors. Preferred equity creates strong protection against default or bankruptcy while still generating stable and predictable investment yields.

Private equity investors typically leave a project once the debt and preferred equity investments are repaid—with interest—hence leaving a larger percentage of the investment to the sponsor and common equity investors. Conversely, if a project fails and only the debt is repaid, the preferred equity investor may need to take control of the project and replace the sponsor.

Related: The Different Ways of Financing Commercial Real Estate

Common Equity

Common equity, or “JV equity,” is atop the capital stack as the last to be repaid but has the highest return potential. It is called “JV equity” because common equity holders own part of the real estate deal with the sponsor in a joint venture.

Common equity investors actually usually collect the largest profit share during the property sale. If a real estate property substantially appreciates in value, higher than the initial outlook, the common equity holders benefit from all the extra unforeseen profit—the upside for common equity investors is unlimited.

Investors interested in a common equity investment should carefully consider all factors of the deal because of the high risk associated as the last to be repaid in the capital stack. Find deals with strong underlying elements to mitigate the risk associated with an otherwise risky position of repayment.

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An Example of a Capital Stack

Office buildings of different heights and widths shaded showing vertical sections showing the real estate capital (not same colors) with Common Equity at the Top of the building and Senior Debt at the bottom. Preferred Equity, Common Equity; Senior Debt, Mezzanine Debt, Common Equity.

Here is an example of a commercial real estate capital stack in which the sponsor wants to purchase an apartment building for $8 million, intending to invest $2 million to improve and stabilize the building.

Varieties of Real Estate Capital Stack

Capital Type

Amount

% of Total

Common Equity

$2,000,000

20%

Preferred Equity

$1,000,000

10%

Mezzanine Debt

$2,000,000

20%

Senior Debt

$5,000,000

50%

Total

$10,000,000

100%

In this case, the senior debt contributes the majority of the financing capital (50%). This, combined with the common and preferred equity, is enough to finance the acquisition of the property. But, the sponsor still needs $2 million to achieve his value-add business plan, so he lines up $2 million in mezzanine debt backed by a short-term bridge loan. The senior debt and mezzanine debt are at the bottom of the capital stack whereas the preferred equity and common equity sit on top and only repaid once the debtors have been repaid, including interest.

Why is Capital Stack Important?

The capital stack of commercial real estate investing is crucial for investors to understand how a project is being financed and the order that financing gets repaid. It provides prospective investors with a sense of the risk associated with their investment, depending on how many others invest, where they rank comparatively in the capital stack and how much of the financing capital is already in the deal.

Here is another way to think about risk: common equity holders in debt-heavy deals are more likely to be left with nothing if things go awry. In deals with lower leverage, common equity holders are more likely to earn at least a portion of their money back, even if the deal does not go perfectly according to plan.

The capital stack also indicates how much equity the sponsor has in the real estate project. Most investors and lenders want the sponsor to have a sufficient capital stake in the deal to ensure their interests all align with one another. The sponsor’s equity is typically included with common equity, but sometimes the sponsor will own a share of the preferred equity, as well.

Related: Liberty Real Estate Fund Explained

Easy To Understand Real Estate Capital Stack

Toy retail store with graphs on either side showing the Capital Stack for real estate which includes Common Equity, preferred equity, Mezzanine Debt Senior Debt at the bottom.

Conclusion

Investors and lenders cannot take a “bad” position within a capital stack; any position can benefit the party.  Other investments and portfolios should also affect the perception of an investor’s stake in the deal. For example, someone with an otherwise conservative portfolio may want to take on the risk of a common equity investment, or vice versa.

Duration of the project is also important to consider; senior and mezzanine debts are typically shorter-term investments than equities since they are repaid first and are the first to be paid out when liquidating. Preferred and common equity investments can last longer with more uncertainty to their duration. Common equity investors should prepare to have their capital tied up for at least a few years, depending on the size and scale of the CRE deal.

While the capital stack creates valuable insight into the risks associated with an investment, investors should understand it as only part of the process of evaluating risk. An investor should do their due diligence and look into other aspects of the deal, including the underlying economics of the deal, the sponsor’s track record, and other risk factors.

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