top of page
  • Writer's pictureKerwin Donis

What Is Capital Stack In Real Estate?

The capital stack helps investors determine how much risk they are taking on when they invest in a real estate deal, as well as their what potential returns will be. Each investor, whether they know it or not, has a position in the capital stack, and this determines the priority they have in relation to other capital in the deal. Assuming the deal performs the way it was projected to according to the underwriting, every investor will receive the targeted returns. But if things do not go as planned, it’s crucial every investor understands where their capital is positioned in the capital stack.


Below, we’re diving into what the capital stack is, and we’re breaking down its multiple components - senior debt, common equity, preferred equity, and mezzanine debt.




1. What is capital stack?


Capital stack in real estate describes the organizational structure of the capital used to purchase a real estate property. This structure also clarifies who has the rights (and in what order) to the income and profits generated by the property throughout the hold period and upon sale. In the event that the property goes to foreclosure, the capital stack outlines who has the rights to the asset itself. The capital stack is often depicted as a graphic to visually show the breakdown between the different types of capital in the deal (sort of like layered cake). The capital stack is essentially the different layers (or tiers) of the financial structure of a deal. It also outlines the priority order investors are paid back from any profits the deal generates during its hold period. Finally, the capital stack details the rights to repayment if there is a default.



Here’s an example:


2. Layers: Senior Debt


Senior debt is at the bottom of the capital stack structure. Senior debt is the foundation of the capital stack. Despite being at the bottom, senior debt is in first-position, because it uses the property as collateral. This means that senior debt has the right to initiate a foreclosure process, take ownership of the property and liquidate it. If the property is performing well and generating enough cash flow to cover their debt service, then everyone gets paid. If the property is not performing well and income from the property is not able to cover debt service, senior debt is the first to be paid before any other capital contributor. Senior debt makes the smallest return on their capital since they are in first position, which means they have the lowest risk of any other capital contributor in the capital stack. 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.


3. Layers: Common Equity


Common equity is considered the riskiest position in the capital stack because they are in last position. This means that they are the last capital contributor to be paid. However, they also receive the highest return on their money to make up for the elevated risk they assume. Common equity still receives distributions from the property’s profits once the other capital contributors have been paid, but these distributions are not guaranteed. They do receive a percentage of the profits when the property sells. A difference between debt investors and common equity investors is that common equity also gets benefit from appreciation. Common equity capital contributors have ownership in the property and rights to it, they pledge it as collateral and are subject to the rules of those lower in the capital stack. In the event that the property depreciates throughout the hold period, there won’t be enough profits to give common equity investors distributions or profit upon liquidation, and they could even potentially lose their part or all of their principal. Many times, common equity comes from the sponsors or general partners themselves. This is because lenders want them to have “skin in the game” by contributing some of their own money into an investment. It’s also important to note that potential returns typically aren’t capped for common equity investors.


4. Layers: Preferred Equity


Preferred equity is the layer of the capital stack between debt holders and common equity investors. So, preferred equity holders require a higher return than any debt holders, but will probably enjoy a lower return than common equity holders. Preferred equity often benefits from any appreciation benefits and profits in the form of distributions.


Many times, preferred equity is structured as a sort of hybrid between common equity and mezzanine debt. Similar to common equity, preferred equity will typically share in some (though less) of the upside of the investment. They may also receive recurring payments like common equity investors.


If it is a hard preferred equity, this means the preferred return must be paid regardless of cash flow. If it is a soft preferred equity, then the preferred return must be paid only if the property generates enough cash flow.



5. Layers: Mezzanine Debt


Mezzanine debt is still below senior debt in terms of priority level, and they aren’t secured by the property, but by a pledge of the ownership interest. They do have limited foreclosure rights, which are restricted by the senior debt agreement. Mezzanine debt receives a higher return than senior debt since they are taking on more risk by being behind the senior debt. It’s not uncommon for mezzanine debt to receive a portion of the sale profits on the backend as well.


Mezzanine debt may share in the profits like common equity, and will typically have a right to receive regular payments at a stated rate not tied to the performance of the investment like senior debt. Most times, mezzanine debt does not have interest in the property. It also is debt and not equity, and they have repayment rights regardless of how the property performs.


Risk and Reward


In real estate, risk comes with every investment. Understanding the capital stack, and your position in it, can help you determine how much risk you are taking on for the projected return you expect to receive. Most investors come in on the common equity or preferred equity level.


22 views0 comments

Recent Posts

See All

Comments


bottom of page