Capital Stack
Demystifying the real estate capital stack
One valuable tool for evaluating risk and return in commercial real estate investments is the “capital stack”. The capital stack depicts the different layers of capital sources that go into funding a real estate project and the relationship between those sources (often shown as a bar graph or pyramid).
The capital stack provides investors with useful information as to the hierarchy of cash flows and risk of repayment to help determine whether the targeted return on investment is worth the assumed risk.
Traditionally, the two main types of capital are:
Equity: which represents an ownership interest in the asset.
Debt: a loan given to the equity ownership typically secured by the property itself.
Risk and Return
As previously mentioned, the capital stack portrays the relationship between the different capital sources of a real estate project. The lower a capital source is on the stack, the lower the risk to that capital as it is the first to be repaid. As such, this lower risk translates to a lower return. The opposite is true as well, with capital sources higher on the stack having greater risk and a greater potential return. This hierarchy of capital sources can also be described as seniority, with the source lowest on the stack having the greatest seniority.
Each real estate deal is unique, and the factors that contribute to the potential risks and returns vary. The structure of the capital stack will therefore also vary from deal to deal. As an investor, it is important to fully understand the potential risks as well as what returns you are entitled to.
Debt
Debt is always lower down on the capital stack as it is the first to be paid back and is therefore senior to the equity. Most real estate debt is provided by traditional lenders, such as banks. Because senior debt is in the most secure position, the return (interest rate) charged is the lowest. Debt also comes with a fixed term, at the end of which the equity ownership must pay back the entire principal plus interest.
Mezzanine Debt
Mezzanine debt often acts as a hybrid between equity and debt. As a hybrid structure, this type of investment is senior to traditional equity but subordinate to the debt. Often the return structure is also a hybrid between true equity or debt, where mezzanine investors receive a fixed payback over a specific term but also may potentially participate in the upside of the investment.
Preferred Equity
Equity owners are in the riskiest position within the capital stack and are therefore the last to be paid back. To compensate for this assumed risk, equity investors typically receive the largest returns. Equity investors, unlike debt, participate in the success of the investment, meaning that their potential returns are not capped but can increase or decrease depending upon the performance of the investment. Because equity investors are owners of the asset, full payout only occurs when the asset or ownership interest is sold.
Common Equity
In most commercial real estate deals, there is a sponsor (manager or developer) that contributes a small portion of the equity and is responsible for the management and performance of the actual investment. The sponsor will raise additional equity (preferred equity) from investors who take a senior position within the equity itself, frequently receiving a preferred return.
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