Capital stack is an often-heard phrase in commercial real estate investment, describing the layers of funding involved in an endeavor, each carrying its level of risk and return potential, along with priority when receiving payments should the property fail to perform as anticipated.
Senior Debt
Senior debt is usually the first layer of financing in a capital stack. It typically takes the form of a commercial mortgage or bank loan secured against the property if a project fails, providing investors with reduced risk and limited upside. Investors in senior debt typically receive lower returns and are subject to more significant limitations on the upside.
Common equity forms the top of a capital stack. It comprises private investors or groups looking for higher returns from their project investment, typically via cash flow distributions and profit sharing based on project profitability. Though more risky than senior debt or mezzanine debt investments, common equity may offer higher returns than senior debt or mezzanine debt investments.
Mezzanine debt is an intermediate form of financing used in capital stacks that typically takes the form of bridge loans or preferred equity. Mezzanine debt offers less risk than common equity, and investors in mezzanine debt usually get paid back before other layers if a project fails; additionally, interest rate payments typically accompany this investment, and an equity kicker or increase may be offered upon successful project completion.
If a project encounters difficulty and cannot generate enough cash to repay all lenders and investors, funds will flow down through its capital stack in descending order of seniority. Senior debt will be compensated first before any leftover cash goes on to the lowest-ranked capital layer (in this example, preferred equity if senior debt has been paid back); any extra proceeds would then be distributed among the next lowest-ranked layer until all of them have received their returns if any are available; otherwise, preferred equity would have no choice but forgo their return – making understanding its structure before making commitments imperative before making commitments!
Mezzanine Debt
The capital stack refers to the order in which investments will be repaid in case of financial distress in commercial real estate projects. Debt investors typically receive priority when compensating, while shareholders usually get whatever is left over after creditors are satisfied. Investors need to understand this concept because it defines risk levels associated with their investment portfolios.
Senior debt is typically the quickest to be repaid and poses the lowest risk among all funding sources due to being secured by property and improvements on it. This allows senior debt holders to foreclose on it if necessary to recoup their initial investment; however, because they don’t benefit from rising rents or property value appreciation upside, they must accept lower returns in exchange for this security and lower risk exposure.
Mezzanine debt sits just below senior debt in the capital stack, offering increased risk but better returns than its lower tiers. Mezzanine loans usually secure property through second-position lien holders. They may include cash interest payments and payment-in-kind (PIK) interest that accumulates throughout its term and is due back when its period ends.
Preferred equity and joint equity investments are just above mezzanine debt in the capital stack. Select equity investors usually include institutional investors such as private equity real estate funds, REITs, pension funds, and sovereign wealth funds that look for higher returns at greater risk; similarly, investors in top positions of the capital stack must accept that they may lose all initial investments should a property perform poorly.
Preferred Equity
Capital stack analysis is a crucial aspect of commercial real estate financing, as it determines the level of risk associated with any given project. An ideal mixture of components is critical; higher-risk investments tend to sit atop this pyramid while less risky assets sit beneath; this mixture also determines return potential.
Preferred equity is an alternative form of financing that sits atop mezzanine debt and common equity but below senior debt in a capital stack, offering investors higher rates of return for taking on more risk than with mezzanine or joint debt investments. Preferred equity holders enjoy greater returns for accepting more significant risks.
Understanding how the capital stack influences real estate transactions is critical for investors, as having an understanding can assist with selecting suitable investment opportunities and increasing returns.
Real estate projects are typically financed using equity contributions and loans (debt) from lenders. If successful, both components will be paid back; if not, both could be affected – leading some investors to prefer an equity-heavy capital stack as this reduces their exposure to the risk of projects not performing as anticipated.
One example is the COVID-19 pandemic, in which some lenders may be less willing to provide as much leverage. As a result, sponsors have added preferred equity into their capital stacks to add necessary power.
Preferred equity holds an advantage over all other forms of debt, including senior and mezzanine, in terms of repayment priority. This ensures selected equity investors don’t suffer losses before other investors in a project do, providing an increased return rate for taking on additional risk.
Common Equity
Common equity represents the highest-risk position in any capital stack yet can yield the most significant rewards. By investing in common equity, investors will receive a more substantial portion of cash flows and profits when selling property; however, funds will only be distributed once all debt-holders and mezzanine debt-holders have received payment on their claims.
Every equity investor is the first to experience losses if the property performs poorly and has the lowest priority for payment; their claim on their portion can only be claimed once all other investors and lenders have received their compensation claims. Joint equity investments typically consist of private equity real estate companies, REITs, or sovereign wealth funds as investors in these positions.
Common equity differs from senior debt, mezzanine debt, and preferred equity by not requiring project owners to retain ownership of the funded property. Therefore, it may be more cost-effective and flexible than other forms of financing for commercial real estate developers seeking alternative funding sources than traditional loans.
Capital stack structures vary based on an investor’s risk-return goals; however, four key components are often included:
Senior debt, mezzanine debt, preferred equity, and common equity are essential in financing commercial real estate projects. Understanding your capital stack helps you accurately evaluate risk and return related to real estate investments.
