Understanding the Capital Stack in Real Estate Deals

In this blog, we will explore the concept of capital stack in real estate deals, breaking down its layers and the differences between them. We’ll cover what capital stacking means in the context of real estate and clarify whether terms like capital stack and capital stacking are interchangeable. By the end, you’ll have a clearer understanding of how these elements are connected and how they play a crucial role in structuring real estate investments.

Capital Stack Meaning: What is Capital Stacking in Real Estate?

A capital stack in commercial real estate represents the various layers of funding used to finance a project or entity, outlining the order of repayment and the associated risk with each layer. It provides a visual framework of a real estate deal, illustrating factors like payment priority, rights, and return potential. Understanding how to structure the capital stack requires evaluating available capital against the cost of capital and considering how it will influence expected returns. By adding equity to the capital stack, investors can reduce debt obligations while maintaining cash flow. However, this may require the lead investor to contribute more of their own money or bring in new investors, from personal networks to large institutional players. While this strategy offers potential benefits, it can also reduce the investor’s control over the asset. Debt, on the other hand, allows businesses to raise capital without giving up ownership rights, and is often preferred for several reasons:

It is more cost-effective than equity, as interest payments are tax-deductible, unlike dividends paid to equity holders.

It boosts return on equity while preserving ownership by raising funds without diluting shares.

It enables private equity firms to leverage debt to amplify their investment returns, with borrowed capital typically generating higher profits than the interest due.

The capital stack, from bottom to top, consists of Senior Debt, Mezzanine Debt, Preferred Equity, and Common Equity. These components can be categorized into two primary categories: debt and equity.

• Senior Debt is the most secure and highest-priority debt layer, meaning it is repaid first in case of bankruptcy. With the lowest risk, it typically offers lower interest rates and is often secured by collateral, such as property or equipment. This reduces risk for lenders who can foreclose on the property if the investment underperforms. Senior debt provides businesses with the ability to take on more debt and stabilizes their finances. Common types include revolving credit lines and term loans with low interest rates.
• Mezzanine Debt acts as a bridge between senior debt and equity, offering higher risk and higher returns. It is considered subordinated debt, meaning it is repaid after senior debt in case of bankruptcy. While mezzanine debt is more flexible and can offer deferred payments and longer maturities, it comes with higher interest rates and fees. It allows companies to raise capital without diluting ownership but can lead to reduced ownership if the debt is converted to equity.
• Preferred Equity is a hybrid of debt and equity that provides investors with priority claims on returns and assets over common equity holders. It offers higher returns than common equity due to its priority claim but lacks the strict repayment obligations associated with debt. However, preferred equity can be complex and may not allow investors to fully benefit from property appreciation. It is also less liquid unless specific provisions are included.
• Common Equity represents the remaining value of a company’s assets after all liabilities, including preferred equity, have been accounted for. Common equity holders have ownership in the company, granting them voting rights and a claim to profits and assets. While it offers the potential for higher returns, it also carries higher risks, as the value of the equity fluctuates with company performance. In the event of liquidation, common equity holders are last in line to receive anything after creditors and preferred shareholders are paid.

The structure of the capital stack plays a significant role in decision-making for commercial real estate investors, influencing the Weighted Average Cost of Capital (WACC), risk management strategies, and return optimization. By adjusting their position in the capital stack, investors can tailor their risk exposure to align with their financial goals. For example, risk-averse investors might prefer senior debt or mezzanine debt for more predictable returns, while those with higher risk tolerance may choose common equity for higher potential returns. In a real estate development project, common equity may be provided by developers, private equity firms, or other investors seeking high-growth opportunities.

What are the benefits of understanding the capital stack?

Understanding the capital stack offers several key benefits that help investors make more strategic decisions. One of the primary advantages is that it promotes a more efficient use of capital. By understanding how different layers of funding interact, investors can maximize the value of their equity contributions. This insight helps ensure that capital is deployed in the most effective way possible. Additionally, understanding the capital stack provides access to a broader range of financing options, allowing investors to combine different types of funding instead of relying on a single source. This flexibility enables investors to tailor their financing strategies to suit their specific needs. Furthermore, the capital stack allows for easier risk diversification, as it clearly delineates the risk levels associated with each layer of funding. By understanding these risks, investors can better assess and compare them, helping them make informed decisions that align with their investment goals.

What is Capital Stacking?

Capital stacking refers to the different sources of funding used in Commercial Real Estate, representing the various layers of capital, including both debt and equity. In corporate financing, these sources often include a combination of equity, debt, and hybrid instruments. Companies typically opt for senior debt because it carries the lowest borrowing costs; however, lenders often impose strict repayment terms and financial covenants to protect their investment. Below are examples of how capital stacking works in real estate deals:

• Common Equity sits at the top of the stack and carries the highest risk and return. Investors in common equity have the most to gain but also the most to lose in a deal. This layer typically represents 20% to 30% of the total capital structure. For instance, if a developer needs $10 million to purchase a property and secures a $6 million bank loan and $2 million in preferred equity, the remaining $2 million would be covered by common equity.
• Preferred Equity represents the money investors contribute to the deal. It typically sits below common equity but has priority over it in terms of return and repayment. For example, if a project requires $10 million in total funding, with $6 million in senior debt and $2 million in common equity, the sponsor might offer $2 million in preferred equity to reduce the amount of common equity needed.

• Mezzanine Debt is secondary debt that fills the gap between senior debt and equity. It can take the form of a second mortgage, such as when the seller provides a second lien on the property. Companies often use mezzanine debt to finance acquisitions or expansions, and sponsors may use it to extract equity from a deal while maintaining control over the project.
• Senior Debt represents the loan obtained from a bank or conventional lender, offering the lowest risk and return. In the event of repayment issues, senior debt holders are paid first. This makes senior debt the most secure layer of the capital stack, but it also typically provides the lowest returns compared to other funding sources.

Each layer of the capital stack plays a crucial role in determining the risk, return, and control in a real estate investment, and understanding how they work together is essential for making informed investment decisions.

Conclusion

In conclusion, the capital stack outlines the relationship between lenders and investors in order of priority, determining who has legal rights to specific assets and income. Senior debt is the first to be repaid in the event of bankruptcy, with banks or bondholders typically holding this position. Mezzanine debt fills the gap between equity and senior debt. Preferred equity has a higher claim to dividends or asset distribution than common equity. Common equity represents the remaining balance of total assets after liabilities and provides the owner with voting rights and a claim to the company’s profits and assets. Therefore, it is essential to understand all the layers of priority and rights before entering any business deals to avoid confusion and manage expectations. This information is crucial for anyone involved in real estate or corporate financing, whether as an investor or a sponsor. It is a vital concept for assessing risk, managing expectations, and making informed decisions.