When investing in commercial real estate, the capital stack is one of the most important things you need to consider. However, many newer investors have trouble understanding the capital stack and why it's so useful when assessing risk and making investment decisions.
With that in mind, here's a quick guide to what the capital stack is, what investors should know about it, and why understanding the capital stack is so important in commercial real estate investing.
What is the capital stack?
In a nutshell, the capital stack is a representation of the financial structure of a real estate deal. It's often presented in a graphical form in investment literature, showing different types of capital "stacked" on top of one another, hence the name.
As a very simple example of a capital stack, let's say that you want to buy an investment property for $500,000. You plan to put 30% down and finance the rest. So the capital stack would look like this:
|Type of Capital||Amount||Percentage|
|Equity (down payment)||$150,000||30%|
Important things to know about the capital stack
With this simplified example in mind, here are a few key points you need to know when looking at a capital stack:
- Capital stacks list the different types of capital in order of least senior on the top to most senior on the bottom in terms of priority when it comes to distributing the cash flows of a property. Equity positions are listed first, with debt positions on the bottom.
- If a property doesn't generate enough money to pay all of its investors, the property's income would flow to the capital listed on the bottom first when payments are being made, and any money left would then flow to the capital listed in the next-lowest position.
- If something goes wrong and there's a default, any debt types of capital typically have a claim to the real estate assets, and these claims will be processed in order of seniority on the capital stack.
- In simple terms, the higher risk capital is at the top of the stack, while the lowest-risk types of capital are at the bottom. Similarly, the higher return potential is typically found towards the top of the capital stack, with expected returns decreasing as you go down to other portions of the capital stack.
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Common types of capital in a capital stack
Theoretically, a capital stack can have any number of layers of debt and equity capital. For example, it's certainly possible to have several layers of seniority when it comes to debt. However, most types of capital in the stack can be grouped into one of these four categories:
Common equity -- Just like investing in common stock, common equity in a real estate investment capital stack has the highest return potential but also comes with the most risk. Common equity holders have the lowest priority when it comes to getting paid, and also in the event of a default. In other words, distributions to common equity holders can only be paid after all the debtholders and preferred equity investors have received their promised returns. In commercial real estate, common equity is typically made up of the capital contributed by investors like you.
Preferred equity -- In the real estate world, preferred equity is somewhat of a vague term. It could mean a type of equity that essentially functions like subordinate debt and pays a fixed return, like preferred stocks do. Or it could simply mean a type of capital that works just like common equity but has superior payment rights to common equity holders. Whatever form it takes, preferred equity typically sits between common equity and debt in the capital stack.
Senior debt -- As the name implies, the lender of this type of debt has the highest claim on a company's assets. In real estate, this usually refers to a mortgage lender or some other type of senior debtholder whose investment is secured by the property itself. It’s the riskiest position to be in because the lender has the right to take possession of the property in the event of default, this debt has the lowest level of risk to the lender. The drawback to senior debt is that it also typically has the lowest potential return.
Mezzanine debt -- This term refers to debt that is subordinate to senior debt in terms of its position in the capital stack. If you have a second mortgage on your home, for example, that would be a form of mezzanine debt. If you default on your obligations, mezzanine debtholders can certainly put a claim on the property in order to get paid. However, they will generally get paid after the senior debtholders. Because of its subordinate nature, in most cases, mezzanine debt real estate investors receive higher returns than senior debtholders. This is why any home equity debt typically has a slightly higher interest rate than you would pay for a primary mortgage.
An example of a capital stack
Here's an example of a capital stack you might see in a commercial real estate investment to buy and renovate an apartment complex for a purchase price of $4 million and a total cost of $5 million:
|Capital Type||Amount||% of Total|
The way this could break down would be that a deal's sponsor might contribute $500,000 in equity capital, and raise an additional $1 million from common equity investors, who would be in a subordinate position. The sponsor may borrow $2.5 million from the bank for the purchase, with that loan secured by the apartment complex itself. It may also obtain a bank loan for $1 million to finance the renovations, which would be in a subordinate position to the purchase loan.
Of course, capital stacks in the real world are typically a bit more complex, but this is the general idea of how it works. As I mentioned, these are typically presented to investors in graphical form, and our example might look something like this:
Why the capital stack is important
There are a few reasons why investors need to pay attention to the capital stack.
First, it tells you who has seniority and how much of the debt is senior. For example, if a property's capital stack is made up of 85% of various types of debt, it's significantly riskier to common equity holders than if the capital stack is just 60% debt-based, all other things being equal. In simple terms, common equity holders in debt-heavy situations are more likely to get left with nothing if things go wrong. A capital stack can help you make more accurate assessments of the risk/reward profile of a particular investment, especially if you're thinking of making a common equity investment.
Second, a capital stack often tells you how much money the sponsor is contributing. This is sometimes listed as a separate type of equity in the capital stack, or it could be included in the common or preferred equity that other investors contribute. Generally speaking, it's good to see a sponsor with a lot of skin in the game -- especially if the sponsor's equity has the same seniority level as other investors.
Third, if you're investing in debt, the capital stack gives you important information on where you stand. In the event of default, you're more likely to recoup your investment if there's less senior debt, for example. And it's not common for there to be several levels of mezzanine debt, so it tells you exactly where you fit in the order.
The capital stack is only one piece of the puzzle
As a final point, while understanding the capital stack can tell you a great deal about the risk/reward profile of real estate investments, it's important to realize that it's just one piece of the puzzle when doing your due diligence.
Different types of real estate deals have different risk profiles. For example, buying a modern, fully-leased apartment building can have much less risk than buying a hotel that's in need of renovations, even if the latter project takes on significantly less debt. So be sure to consider the big picture, not just the capital stack, when trying to assess risk.