Real estate investing doesn’t have to be complicated. This article breaks down the capital stack, a fundamental concept in real estate investing.
What is the Real Estate Capital Stack & How Does It Work?
A real estate capital stack is most commonly composed of four layers: Senior Debt, Mezzanine Debt, Preferred Equity, and Equity.
Each layer in the capital stack has a different risk and return profile. Senior Debt is the least risky, but provides lower returns than other tiers. Likewise, Equity is the riskiest but has the greatest potential upside.
Each capital stack layer has advantages and disadvantages while serving a specific purpose in real estate investing.
Whether investing in real estate crowdfunding or publicly traded REITs, understanding the capital stack can make you a more educated investor and help you build wealth through real estate investing.
When analyzing a potential investment, too many investors become enamored with the returns and upside potential while ignoring the risk – a critical but common mistake.
Senior Debt: The Foundation
Senior Debt is the largest and least risky layer of the Capital Stack. Senior Debt can make up 50% – 80% of a commercial real estate capital stack, derived from the property’s purchase price.
Senior Debt holders are first in line in the event of default. Investments are collateralized by a deed of trust or mortgage against the property, which means Senior Debt holders claim the title if the borrower defaults. And, because senior debt holders can claim the title, the physical collateral provides a greater degree of security for investors.
Plus, Senior Debt is structured to demand monthly interest payments at a set rate and its returns aren’t tied to the underlying investment’s performance.
For this degree of security, Senior Debt holders forgo greater return potential for a safer investment and stable income.
Pros
- Secured by physical property
- Predetermined interest payment
Cons
- Sensitive to inflation
- Lowest returns compare to other layers in the capital stack
Mezzanine Debt
Next in a commercial capital stack is Mezzanine Debt, which typically comprises 10% – 20% of a real estate deal’s purchase price. Mezzanine debt has characteristics of Senior Debt and Common Equity.
Like Senior Debt, Mezzanine Debt holders have a right to regular payments divorced from the performance of underlying real estate investment. Like Common Equity, Mezzanine Debt investors also share a portion of any profits, although at a considerably lower level than the pure equity holders.
Mezzanine Debt provides higher return potential to investors than Senior Debt because of its increased risk, since it isn’t secured by property and has limited foreclosure rights.
Mezzanine Debt can have a fixed or floating interest rate, which can vary depending on the Loan-to-Value (LTV) of the deal.
Investors in Mezzanine debt can earn between 10% – 20% returns. This risk/reward profile makes this capital stack layer very attractive to most real estate investors.
Pros
- Higher payment than senior debt because of increased risk
- Can share in the potential upside while also securing guaranteed payment.
Cons
- Limited foreclosure rights
- Lowest returns compare to other layers in the capital stack
Preferred Equity
Preferred equity in the capital stack represents a hybrid structure sharing characteristics of common equity and mezzanine debt. Preferred equity usually makes up 5% – 20% of a real estate deal purchase price. Preferreds are usually structured as ‘hard’ preferred, which is less risky, or ‘soft’ preferred, which is riskier more comparable to standard equity offerings.
If the preferred equity is classified as ‘hard,’ it means payments must be paid regardless of cash flow or performance. If payments go unpaid, specific remedies kick in that include taking control of the investment or forcing its sale. These stipulations make hard preferred investments more like mezzanine debt and therefore less risky.
If preferred equity is structured as ‘soft,’ it means payments are only required when there’s sufficient cash flow. There aren’t necessarily remedies if payments aren’t paid, making soft offerings similar to the common equity layer.
Pros
- Safer return
Cons
- Principal at risk
Common Equity: The Icing On The Cake
At the very top of the real estate capital stack is common equity or, as I like to consider it, the icing on the cake. Common equity investments in real estate are the riskiest layer but offer an opportunity for the highest returns. Common equity comprises 5 – 10% of a real estate deal’s purchase price.
Because equity investments don’t have a secured interest in the property, and aren’t entitled to recurring payments, there’s a possibility investors lose some or all of their initial investment.
Potential returns in equity investments are usually uncapped, and investors receive returns only after the base tiers in the capital stack are repaid.
Gains from equity investments come from property capital appreciation, so investors usually don’t realize returns until the property is sold or a liquidity event kicks in.
When you invest in the equity layer of the capital stack, you’re usually invested at the same level as the sponsor. The sponsor’s position is colloquially known as ‘skin in the game,’ incentivizing them to maximize returns for their own benefit alongside equity investors.
Pros
- Greatest upside potential
Cons
- Riskiest level of investment
Why does the Capital Stack Matter?
From an investor’s perspective, understanding the capital stack is critical because it can help determine the overall risk/reward profile. All commercial real estate investments are built on a foundation of some combination of capital stack layering.
If you’re an individual investor with many years until retirement, you may be more inclined to invest in the equity layer since this option may generate hefty returns primarily through capital appreciation.
On the other hand, if you’re closer to retirement age, investing in debt may be more appropriate since these layers focus on income kickbacks and is relatively safer since it’s secured by the underlying property.
