Investors who are interested in assessing the risk and predicted returns for a real estate investment should understand the concept of a Capital Stack. Your investment can be designed to mitigate excessive risk or structured for sufficient potential profits by utilizing this model to evaluate tradeoffs. It is one of the most important ways to assess a prospective investment in a commercial property because it explains the order in which debt holders and investors will be paid and even demonstrates the degree of risk each will incur. All these factors are crucial when the potential risk and reward for a particular investment are under consideration.
Related: Best Real Estate Investment Options for Accredited Investors
What is a Capital Stack?
The different sources of capital or money used to buy and run a commercial real estate venture form something known as a “Capital Stack.” This stack specifies the lenders and investors that have contributed funds to the venture, as well as the order in which they will receive returns from the property. It also clarifies who has the first right to foreclose if the sponsor defaults on his payments and promises regarding the property that is used as collateral.
The four components of the Capital Stack are usually: senior debt, mezzanine debt, preferred equity, and common equity. Common equity is the lowest in priority, and these investors receive payment last. The strongest priority is given to senior debt lenders. These lenders receive payment first.
Each layer in the Capital Stack carries its respective positives and negatives. Read further to learn more!
Why Is a Capital Stack Important?
One of the most crucial concepts an investor needs to understand to evaluate his risk-return profile is the commercial real estate assets Capital Stack. Like other investments, commercial real estate involves a certain degree of risk. Investors who are familiar with Capital Stacks and their position in it can evaluate their risk and repayment better, where they would fit into the hierarchy of generated cash flows, and whether an investment is worthwhile given the estimated risk.
The entire capital stack is crucial because it gives a clear picture of each lender and investor class’s stake in the asset and clarifies who would ultimately possess the asset if the sponsor (and debt borrower) stopped making payments.
Four Layers of Capital in Funding
To fully comprehend a Capital Stack, it is necessary to understand its layers. Knowing the differences between the four layers is critical.
Looking to find your place in the stack? Get in touch with us to learn where SecondRE investors fit in.
Senior Debt
A mortgage lender or another debt holder with the greatest claim over the overall value of the asset becomes the senior debt in the stack. This is the position with the least risk because if the borrower doesn’t make the mortgage payments, the lender can seize control of the property through foreclosure proceedings and can even sell the property to recoup the debt.
Priority is given to senior debt above all other capital stack levels. Senior debt lenders must be paid the amount due at any given period before the other lenders and investors receive any investment returns.
Mezzanine Debt
After the full payments to senior debt have been met and all operating costs have been paid, any remaining funds generated by the asset will be used to pay off mezzanine loans. Mezzanine debt follows senior debt regarding its standing within the Capital Stack and its overall payment priority.
Mezzanine debt for a business is similar to a home’s second mortgage or even a HELOC. Mezzanine debt normally has a greater return rate than senior debt due to its secondary character, comparable to how a home equity loan typically has a greater interest rate than a primary mortgage. Any lender that gives a loan for an asset already leveraged with an existing loan takes a greater risk than the first lender, and therefore asks for a higher interest rate to compensate for such heightened risk.
Related: Real Estate Investment: The Holding Period Explained
Preferred Equity
The preferred equity stack is a lower risk level because the right of repayment for the preferred equity layer receives precedence over that of common equity. It also comes with more certainty because it includes a preferred rate of return.
However, the preferred equity stack has a lot of flexibility in how it can be structured. This means choosing between either hard or soft investments.
Hard investments are less risky. In most cases, the preferred return must be paid even if cash flow and performance would otherwise prevent it. If these payments aren’t made, remedies could include forcing the sale of the investment or the investor invoking the right to take control of it. Because of this, hard investments at the preferred level tend to be more similar to that of the mezzanine layer.
On the other hand, soft investments are more similar to the common layer. Payments are only required if cash flow is sufficient. Based on the agreement, there may or may not be remedies if payments are not met.
Common Equity
Lenders frequently require sponsors or developers to invest a portion of their funds through common equity. Common equity, the riskiest but possibly most lucrative component of the capital stack, is contributed by the operator or sponsor and the regular investors of the property. This layer is where you would find most investors.
Investors that fall into the common equity category are the last in line to get paid. Debt must be paid off, and the preferred equity layer must receive their payments before these investors get paid. However, typically, these returns are not capped. If an investment is very successful, investors in the common equity layer could see very sizeable returns.
In most cases, the returns for preferred equity are better than those for common equity.
Related: As Stock Markets Devalue, Real Estate Stands as a Safer Investment Track
SecondRE: Secondary Trading of Equity Holdings
SecondRE operates a marketplace where investors can buy and sell fractions of commercial real estate investments. This makes investing in real estate much easier.
These investments are typically classified as “Common Equity”. This means that the project’s sponsor gives priority to the debt holders – priority debt and mezzanine debt – before paying out to the equity holders. Still, it also gives investors a chance to earn higher potential returns from performing assets once the debt payments are made.
Understand How the Capital Stack Affects You
If you’re interested in investing in real estate, you must understand exactly where you would fit into the capital stack. After all, this impacts what potential risks and rewards you are facing, as well as your rights as an investor.
Make sure you understand your potential position and everything it entails before investing in any venture.
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