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What Is a Capital Stack?
Understanding the capital stack is critical for commercial real estate investors to evaluate potential risk and return on investment.
Capital stack gets thrown around a lot as a term in commercial real estate investing. Simply, it refers to the layers of capital involved in a real estate investment.
Each layer has a different level of risk, different potential returns, and a different priority when it comes to receiving payments. The graphic below depicts a capital stack for a commercial real estate investment. Simply put, the bottom of the stack has the lowest risk — and the lowest returns. As you move up, the risk and potential investment upside increases.
Curious how it all comes together? This article explains the meaning behind each capital stack position, as well as the core components — debt and equity — and how an investor can better understand an investment’s risks and profitability given the structure of a particular investment.
Debt Layers of the Capital Stack
There are two main debt layers in the capital stack. Both aren’t present in all real estate investment structures — in fact, many smaller assets are acquired using only senior debt. Mezzanine financing, however, may be available in your situation, and it is key to understand how it falls into this structure.
Also known as a first-position mortgage, senior financing is the primary (and usually largest) loan you take when acquiring a property or refinancing a prior loan. There’s no one type of lender that offers senior financing — it could be anything from a bank or credit union to a life insurance company or CMBS lender.
Senior financing is paid off over time through regular debt service payments and, depending on the loan terms, a balloon payment at maturity. Senior debt occupies the lowest layer of the capital stack, meaning it is the first to be repaid and bears the lowest risk. A holder of senior debt can also foreclose on a property.
Mezzanine financing, also sometimes referred to as subordinated debt, is a layer of debt that is — as the name suggests — subordinate to the more senior loan. That means that the senior lender gets paid before the mezzanine lender gets their return. This is a riskier type of financing for lenders to offer. As a result, this loan type generally bears a higher interest rate to offset that risk.
Note that not all senior lenders will permit an investor to take mezzanine financing. For example, in multifamily real estate, HUD lenders typically do not allow it, and even agency lenders like Fannie Mae® or Freddie Mac® will only allow mezzanine debt from approved sources.
Image by Alexander Grey from Unsplash.
Equity Layers of the Capital Stack
The equity in the capital stack describes which investors own the property without debt. There are different layers in equity, however, and it’s important to note the differences between them.
If you’re the one buying a property, preferred equity isn’t you. That’s down in the next section. But imagine you’re purchasing a $15 million multifamily property. You can get a loan for $10 million, and you have $2 million of your own capital to inject. Where do you get the other $3 million? That’s where preferred equity comes in.
If mezzanine financing is too expensive (or unavailable) for your deal, you could sell preferred equity to outside investors, offering them a guaranteed return through a type of waterfall structure. Let’s say in the above example, you sell $3 million in preferred equity, with a guarantee of a 6% annual return on investment. Because it’s lower on the capital stack, preferred equity returns are prioritized above your own returns. After you pay your debt layers in full, your next step is to cover the preferred equity returns, at whatever rate was guaranteed.
Last but not least, common equity is your contribution to the investment. This may not just include your own skin in the game, but that of other investors if you’re investing as part of a real estate syndication or even through crowdfunding.
With common equity, you stand to realize the biggest investment gains. Returns aren’t limited like they are with debt or preferred equity. However, with the opportunity for larger gains comes a significant increase in risk. Common equity has the lowest payment priority. That means if your investment sours, you could be on the hook for a significant loss — even if all the debt layers and preferred equity are made whole.
Allocation of Risk, Payment Priorities in the Capital Stack
In commercial real estate, every investor has a different tolerance for risk — and the capital stack is a good way to understand how much risk each level of capital has. Senior debt, which occupies the bottom — and often largest — layer, has the least amount of risk.
Think of it this way: If you bought an underperforming office building with a bank loan, and you don’t get enough rental income to cover both debt service and your own projected returns, who gets made whole? Hint: It isn’t you.
A lender behind a senior loan is always the first to receive its piece of the pie — and so it has significantly less risk in any investment. Of course, lenders do bear some risk. If that office building sits empty, it’s unlikely anyone’s getting paid much of anything. Of course, to manage this risk, a lender has the option to foreclose on a property when the borrower can’t service the senior debt.
Similarly, the actual property owner — often portrayed in the capital stack as the common equity — bears the greatest amount of risk. Commercial real estate owners have the lowest priority in terms of getting paid, as any debt and preferred equity must be paid out first.
How Returns Differ Within the Capital Stack
As with nearly any investment, higher risk isn’t necessarily a bad thing. While the common equity layer of the capital stack may bear the highest risk, for example, so too can it bear the greatest rewards. On the other hand, while a senior mortgage lender at the bottom of the capital stack may have very little risk, if an investment performs well, the lender generally won’t realize any additional return.
By the same token, though, a large amount of risk can certainly turn an investment opportunity into a liability. Beyond the cash flow example from the previous section, an investor higher up in the capital stack is at risk when exiting an investment.
For example: Let’s say you acquired a retail property for $5 million, and you utilized $3.5 million in senior debt and $1 million in preferred equity for the deal. You exit the investment after property values have dropped significantly in your market, or after the asset type begins to struggle at even a national level. We’ll say you sell the property for $4.3 million.
The lender will still get their cut. Of that $4.3 million, they’ll take back whatever is left to be paid on the loan. Then, the remaining money will pay out the next level of the capital stack: in this example, preferred equity. There may not be enough money to fully cover what’s due to preferred equity holders, but they will still take as much of their cut as they can. That could leave you with nothing, unless the preferred equity layer is made whole. Of course, in normal market conditions, property values will increase — but even so, it is wise to understand how the capital stack influences your overall return on investment.
What is the definition of a capital stack?
A capital stack is the legal organization of all the layers of debt that are used to purchase, build, or renovate a piece of real estate. The position of a piece of debt in a property’s capital stack determines what the order that lender will repaid in the case of a borrower default or bankruptcy. The general components of a real estate capital stack include:
- Equity: Funds directly placed in the project by owners/investors. Typically consists of a down payment between 20% and 30% for most projects. Equity investors are the last to be repaid if the borrower/borrowing entity declares bankruptcy.
- Preferred Equity: Equity in the project that effectively functions as debt. Preferred equity investors are paid a specific interest rate (often 10% or more), and generally participate in the upside of a project if it reaches a certain level of profitability (in the form of an equity kicker).
- Mezzanine Debt: Mezzanine debt is subordinate to a first or second position mortgage, and generally carries significantly higher interest rates (often between 9 - 16%). Most mezzanine debt has 5 - 10 year terms and is interest-only. Mezzanine loans usually occupy about 15% of a borrower’s capital stack. Mezzanine debt is similar to preferred equity, and mezzanine lenders and preferred equity investors both use shares in the borrowing entity as collateral.
- 2nd Position Mortgage: Technically, a second position mortgage is any mortgage that is subordinate to the primary mortgage, such as the mezzanine financing mentioned above. However, in other cases, a second position mortgage can take the form of a private money or hard money loan, which is especially popular for borrowers with credit or legal issues, or those who need to close especially quickly. The major difference most second position mortgages and mezzanine debt is the fact that most second position loans can actually secure a junior lien against the property instead of a lien against the borrowing entity.
- 1st Position Mortgage: The first position loan, or senior loan, is the primary loan on a commercial property, usually consisting of between 55% to 75% of the purchase price of the property. First position loans are secured by a first-position lien against the property, and have first payment priority in the case of a bankruptcy. Only tax liens are superior in priority to a first-position lien on a commercial property.
While many commercial real estate projects may only have two layers in the capital stack, larger and more complex projects may have up to 4 (or even more) layers. However, most complex projects generally have 3 layers; owner equity, a mezzanine or junior loan, a first position mortgage, and a second position mortgage.
What are the components of a capital stack?
A capital stack is composed of two main components: equity and debt. Equity describes which investors own the property without debt, and there are different layers in equity. Debt layers in the capital stack include senior debt and mezzanine financing. Senior debt is often used for smaller assets, while mezzanine financing may be available in certain situations.
How does a capital stack affect a commercial real estate transaction?
The capital stack in a commercial real estate transaction is the legal organization of all the layers of debt used to purchase, build, or renovate a piece of real estate. The position of a piece of debt in a property’s capital stack determines what the order that lender will be repaid in the case of a borrower default or bankruptcy. The components of a real estate capital stack typically include Equity, Preferred Equity, Mezzanine Debt, 2nd Position Mortgage, and 1st Position Mortgage. Equity investors are the last to be repaid if the borrower/borrowing entity declares bankruptcy. Mezzanine debt is similar to preferred equity, and mezzanine lenders and preferred equity investors both use shares in the borrowing entity as collateral. First position loans are secured by a first-position lien against the property, and have first payment priority in the case of a bankruptcy. Most complex projects generally have 3 layers; owner equity, a mezzanine or junior loan, and a first position mortgage.
What are the advantages of a capital stack in a commercial real estate transaction?
The advantages of a capital stack in a commercial real estate transaction are that it allows for a more efficient use of capital, as well as the ability to spread risk across multiple lenders. By having multiple layers of debt, the borrower can access more capital than they would be able to with a single loan. Additionally, the capital stack allows for the borrower to access different types of financing, such as mezzanine debt and preferred equity, which can provide more flexible terms than traditional debt. Finally, the capital stack allows for the borrower to spread the risk of default across multiple lenders, which can help protect the borrower from a single lender's default.
What are the risks associated with a capital stack in a commercial real estate transaction?
In commercial real estate, the capital stack is a way to understand how much risk each level of capital has. Senior debt, which occupies the bottom — and often largest — layer, has the least amount of risk. If the borrower defaults on their loan, the senior lender can attempt to foreclose on the property.
Mezzanine loan and preferred equity investors may take over the borrowing entity, but to maintain control of the property, they will need to continue paying the first position lender, who may need to pay property taxes if they are not taken care of by the mezzanine lender or preferred equity investors.
The actual property owner — often portrayed in the capital stack as the common equity — bears the greatest amount of risk. Commercial real estate owners have the lowest priority in terms of getting paid, as any debt and preferred equity must be paid out first.
To manage the risk, a lender has the option to foreclose on a property when the borrower can’t service the senior debt.
What are the best practices for structuring a capital stack in a commercial real estate transaction?
The best practices for structuring a capital stack in a commercial real estate transaction depend on the size and complexity of the project. Generally, the capital stack should include owner equity, a mezzanine or junior loan, and a first position mortgage. For larger and more complex projects, additional layers of debt may be included, such as preferred equity and second position mortgages. It is important to note that the position of a piece of debt in a property’s capital stack determines what the order that lender will be repaid in the case of a borrower default or bankruptcy. For more information, please see this article on capital stacks in commercial real estate.