What is the Capital Stack?

What is the capital stack?

In simple terms, the capital stack is the underlying financial structure of any commercial real estate deal, specifically in a private equity real estate deal .

They call it a stack because it refers to the layers that go into purchasing and operating a commercial real estate deal.

It's primarily made up of debt and equity. And it also lets you know who gets paid and in what order and how much risk each layer carries.

So, knowing the stack is incredibly important when it comes to determining the risk and reward that any given investment in the stack is made.

Here’s a simple way to look at the stack. For example, in residential investing, there are two components. There is the down payment, which is the equity portion. And then there is the mortgage, which is the debt portion.

Capital Stack Layers

The capital stack in Private Equity Real Estate investing is usually made up of four sections and in the following order.

Senior Debt

At the very bottom is what's called the senior debt. It's a first mortgage usually provided by a bank. So, it's the bank loan. It's paid first in any distribution of funds, and should the investment go into any kind of foreclosure or litigation should the fund not meet the loan’s obligations? It's the first one in the stack to get paid. So, therefore, it's the lowest risk, but it also has the lowest interest rate.

Mezzanine Debt

The next layer in the stack is mezzanine debt and it's a hybrid of debt and equity.

So, what that means is that there is a debt portion paid which is the interest component associated with it. As the profits are made, there's an interest paid on a regular basis. But there's also an equity component. This is where the mezzanine debt usually has the option to convert itself into equity. So, it could eventually own shares in an investment.

The key thing about mezzanine debt is it's not secured. As a result, it's got a higher interest rate with it and earns a higher rate of return than the first mortgage than the senior debt. This is because it's riskier. But, as I said, sometimes it has the right to convert to equity.

Mezzanine debt is usually temporary. Mezzanine debt usually lasts for about a year. And then the investment will do something to buy them out. That could be a dividend restructuring. Or the mezzanine debt could execute their right and they could convert their debt into equity.

Preferred Equity

The next layer is preferred equity. This is ownership in the investment and not debt.

This is where the limited partners come in. This is where the investment raises money from individual investors called limited partners in an LP. I say individual investors, but it could also be a company that's in there. So, these are the equity investors which are the limited partners in the Private Equity Real Estate deal which is structured as a limited partnership.

Common Equity

And then finally at the top stack is the common equity or the sponsor equity.

This is where the owners, the founders, the general partners come in.

So, the lower the stack or the lower the position in the stack, the lower the risk, and by intention the lower the return. The higher positions typically earn higher returns and the result is higher levels of risk.

Example of a Capital Stack

I'm going to walk through a typical stack. Let's say you're going to be purchasing a $10 million property.

So, the bank puts up 50% as the first mortgage, which is $5M and earns a 6% return on their investment. So, they make a 6% return on that loan, on that mortgage. The Private Equity limited partnership has an obligation to pay that mortgage or the bank could foreclose

Next, you have a second mortgage, which is the mezzanine debt, and let’s say they loan 20% of the purchase price. So out of the $10M, they are going to put up $2M. And as a result, they're going to get paid a set amount on a defined schedule, just like the 1st mortgage holder. Plus, the mezzanine lender could convert their loan into an equity position.

The next is the preferred equity. So, this is where the private equity firm is going to go out and they are going to raise money from investors from their limited partners. So, let’s say they raise 20%, which is $2M. And let’s say they are going to get paid 8% on their investment. Now, the advantage here with preferred equity is that they could also get some additional earnings which is the interest from any profits above and beyond what they get paid at their 8% base rate.

And then finally, the common equity portion of the stack, which is the actual investment from the owners, from the founders, from the sponsors. And that only leaves 10% that they would have to invest from their own capital. So, 10% of $10M is $1M. So, to purchase this property, the owners would only have to invest $1M and they would arrange for financing from all those other different levels of equity and debt. Keep in mind most banks will have minimum requirements that they would want to own to put up so the owners will have some “skin in the game”. This ensures they have something to lost.

The thing about common equity though, is that the sponsors only make money after profits, but they also get paid from other sources. For example, they get paid fees. Sometimes there's an acquisition fee and a management fee. And then there's also a carried interest which means they will get a portion of interest above and beyond all profits after paying any debt and equity obligations. And then they also can get paid if there's a dividend recapitalization.

So that's what a capital stack looks like in private equity real estate investment for a commercial real estate deal.