C&A - Understanding the Capital Stack

The investment term “capital stack” is comprised of the total capital invested in a project. In commercial real estate, these “stacks” typically include common equity, preferred equity, mezzanine debt and senior debt. Each of these investment levels comes with its own unique risk and rewards. Typically, higher positions in the capital stack earn higher expected returns due to their higher risk.

One of the most important parts of investing in commercial real estate is performing due diligence. This includes determining the place you want to be on the capital stack based on your investment objectives and the details of the specific deal you are analyzing. Understanding the capital stack structure is a key component in building a diversified portfolio.

The capital stack is arranged in the following order:

Common Equity: At the top of the capital stack, this layer contains the most risk of all of the layers in the capital stack. When an investor invests in common equity of a project they are taking an ownership stake in the project. The risk at this layer is greater because the owners of the project are only repaid after all of the other positions in the capital stack are repaid. To compensate investors for this increased risk, equity investors have a pro-rata interest in all of the upside of the project after the other positions have been repaid.

Preferred Equity: Another form of equity in a project, and next in line in the capital stack, is preferred equity. This layer in the stack is senior to common equity investments but still subordinate or lower in priority to debt. Preferred Equity allows investors to receive prioritized payments ahead of common equity holders, as well as some percentage share of the total capital gain of a project. As it does contain some measure of seniority to common equity, both the expected risk and potential upside is slightly lower than common equity.

Mezzanine Debt: The first form of debt in the capital stack is mezzanine debt. Along with preferred equity, this category is considered to be a hybrid structure as it contains seniority to equity positions within the stack but is subordinate to senior debt. Mezzanine debt investors demand a higher rate of return than senior debt investors due to their unsecured position, meaning that it only gets repaid after all senior obligations have been satisfied. Being a hybrid of sorts, mezzanine debt typically pays periodic interest payments to investors with the potential for additional compensation coming in the form of a small shared interest in future upside or additional accrued interest.

Senior Debt: The foundation of the capital stack, and typically the majority of the stack, is senior debt. Senior debt is generally secured by the property, which serves as collateral for the loan. The risk of this category is typically considered to be the lowest of all of the layers in the stack due to its security interest in the collateral. Senior debt holders receive contractual ongoing interest payments before the investors in the higher layers in the capital stack. The relative security afforded to senior debt means it has the lowest level of reward when the interest payments are set.

Picture This Capital Stack

Imagine an object like a triangle or a prism, with an open, narrow top and wide, closed base. Now, imagine this object is empty. In order for a real estate investor to purchase property A at $500,000 (list price plus rehab cost), he needs this object filled with that much money. The investor secures a loan from lender X (debt financing) for 80 percent, or $400,000, of the list price, he drops this money into his prism piggy bank.

He then secures another $50,000 from lender Y (debt financing), which he also deposits in his prism. The investor fronts $25,000 (equity financing) using his own cash and collects another $25,000 in cash (equity financing) from the developer. This also drops it into his piggy bank.

To recap, the investor now has a prism with four levels of capital:

• Level 1, the bottom level, (Senior Debt) from lender X: $400,000
• Level 2 (Mezzanine Debt) from lender Y: $50,000
• Level 3 (Preferred Equity) cash from the investor: $25,000
• Level 4, the top-level, (Common Equity) cash from the developer: $25,000

The investor now uses the money in his prism piggy bank, from top to bottom, to purchase the property, rehab it, and pay for any associated renovation fees. Then, he sells the property for $600,000. Visualize the investor pouring this money back into his empty piggy bank. The senior debt, or bottom level, takes precedence, therefore, the $400,000 plus interest, returns to Lender X.

Then, lender Y receives $50,000 plus interest, followed by the $25,000 paid back to the investor and developer. The equity financiers, the investor and the developer receive the remaining money, with the developer receiving a bigger portion because of his position at the top of the capital stack.