Capital Stack Real Estate: The Full Guide
All too often, real estate investors will jump to a deal’s projected returns and make their decision about whether or not to invest accordingly. This overlooks one of the most important concepts in commercial real estate: the capital stack. The capital stack is a key component for investors weighing the potential risks and returns associated with any specific real estate deal.
Understanding a deal’s capital stack allows investors to weigh the potential tradeoffs. Is the sponsor taking on too much leverage, and therefore, putting equity investors’ at too much risk? What is the likelihood of repayment if things don’t go exactly as the sponsor planned? The answer to questions like these can all be informed by looking at how the capital stack is structured. The capital stack determines who gets paid, how much, and in what order – something no investor should ever overlook.
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What is a capital stack in real estate?
In theory, and on occasion, commercial real estate is purchased using 100 percent equity. However, in practice, most sponsors see the value in taking on some degree of leverage when acquiring a commercial asset. Leverage, usually in the form of a traditional bank loan or other types of companies who provide debt for real estate acquisitions, can help to amplify returns for investors.
The resulting combination of debt and equity is what is often referred to as the “capital stack” in real estate. Capital stacks can vary widely from deal to deal, both in the type of capital used and how much of each capital source is used.
An important role of a commercial real estate sponsor is to figure out how to structure the capital stack and then procure the capital needed to finance the transaction accordingly. Two sponsors looking at the same exact deal might decide to approach the capital stack differently. For example, a more risk-averse sponsor may utilize less leverage than someone else who is willing to take on more debt (which, by extension, increases the deal’s risk profile).
Capital stack definition
The capital stack in real estate is simply the organization of all debt and equity used to finance a real estate transaction. There may be more or less debt vs. equity used for any given transaction, and the types of debt and equity can vary from one transaction to the next.
For example, a property purchased for $20 million may be financed with 60 percent debt and 40 percent equity. The $12 million in debt might be primarily senior debt ($10 million) and for whatever reason, the sponsor may need to utilize another $2 million in mezzanine debt. The remaining $8 million needed comes in the form of equity, which can be structured as either preferred equity or common equity depending on the nature of the deal.
How does a capital stack work?
The real estate capital stack is structured into four components: senior debt, mezzanine debt, preferred equity and common equity. Despite this order, and somewhat counterintuitively, senior debt falls at the “bottom” of the capital stack. Mezzanine debt, preferred equity and common equity then follow. As one moves up the capital stack, the risk and return profile for the capital increases. Senior debt is considered the lowest risk but in turn, generates the lowest returns. Conversely, common equity is considered the highest risk but offers the potential for significantly higher returns.
In commercial real estate, each transaction will be financed using some combination of the debt and equity sources shown in the capital stack diagram featured below.
Capital stack diagram
The example below shows what a capital stack might look like on paper, especially in terms of risk and potential rewards.
“Senior debt” can go by several names, from “bank debt” to “first mortgage” or “senior loan”. The most important thing to know about senior debt is that it holds the highest priority position in the real estate capital stack, meaning that it has a recorded legal document entitling the lender to the first claim on the property’s cash flows and/or sales proceeds. Because the senior debt holds this highest-priority position and will be guaranteed repayment before all others, it is considered to have the least downside risk. It correspondingly has the lowest interest rates, or returns, for investors.
Most senior debt is provided by traditional bank lenders like Wells Fargo and JPMorgan Chase. Institutional investors, like life insurance companies and pension funds, will also frequently invest in senior debt.
Loans can be made at either a fixed amount or with a floating interest rate that is repaid monthly according to an amortization schedule. Assuming the senior debt is repaid on time and in full, the senior lender will not share in any additional upside. Therefore, if a property outperforms its original expectations, the lender will still only receive the interest rate agreed upon in advance. This is why senior debt investments are considered to have limited upside.
However, senior debt is attractive to those with a low-risk tolerance. This is because, if a sponsor fails to repay the senior debt, the lender has the ability to take back the property through foreclosure or other means. This is what people refer to when they say a property is in “default”. Of course, lenders generally try to work with borrowers before repossessing a property. Most lenders are not in the business of owning an operating real estate, and therefore, will usually pursue loan modification or restructuring before resorting to foreclosure.
Equity investors are usually supportive of sponsors taking on senior debt, particularly if that debt is available at attractive rates and terms. This is because the use of leverage can enhance investors’ returns, assuming the deal goes according to plan.
Mezzanine debt is the next position within the real estate capital stack. It is sometimes referred to as “subordinate debt,” “sub-debt,” “junior debt,” a “second mortgage” or simply “mezz”.
Mezzanine, which means “middle” in Italian, refers to the position this capital takes within the capital stack. Mezzanine debt is repaid after senior debt but prior to preferred or common equity.
Whereas senior debt is secured by the property, mezzanine debt can be either secured or unsecured. From a lender’s perspective, mezzanine debt is “safer” when secured by the property, but in reality, a deal with significant senior debt gives the senior lender first priority to the asset ahead of the mezzanine lender, which puts the value of that security in question. Most borrowers prefer to have unsecured mezzanine debt as “secured” debt is often looked at as a liability when analyzing a sponsor’s larger investment portfolio.
Because mezzanine debt is repaid after senior debt, it carries a slightly higher risk profile. In turn, investors can expect to earn higher returns. Whereas senior debt might earn a 3-4% interest rate, mezzanine debt can range from 8-14% interest or more. Given the higher cost of mezzanine debt, most real estate sponsors will seek to maximize the amount of senior debt they can obtain prior to utilizing mezzanine debt.
Mezzanine debt is typically provided by investors who are comfortable owning and operating real estate. This is because, in the event of default, the senior lender is repaid first and the mezzanine lender may have no choice but to take back the asset (or management thereof) in order to recover their losses. Therefore, most mezzanine debt is provided by private equity real estate investors.
Preferred equity is the next in line in the real estate capital stack. Preferred equity, sometimes referred to as just “pref,” functions similarly to mezzanine debt. It is generally offered at similar interest rates (8-14%) but it is structured as an equity investment into the entity (LLC, trust, etc.) overseeing the deal rather than a loan to that entity.
Preferred equity and mezzanine debt are generally used for the same purposes. In both cases, a sponsor will seek mezzanine debt or preferred equity when they are, for one reason or another, unable to secure sufficient senior debt. In practice, most sponsors will use either mezzanine debt or preferred equity. Rarely will deals include both. Another similarity to mezzanine debt is that preferred equity tends to be provided by private equity real estate investors who have the knowledge and expertise to take control of the property in a worst-case scenario.
Common equity is the equity investment made by both the general partner (the sponsor) and limited partners (passive investors). Common equity holds the lowest priority position and sits at the top of the real estate capital stack. It is the last investment to be repaid, and will be repaid only if the others are repaid first. Therefore, common equity carries the highest risk but also offers the potential for the greatest reward.
For example, a commercial real estate deal might be expected to generate 15% cash-on-cash returns for common equity investors. These projected returns are not guaranteed, but rather, are made based on the sponsor’s initial underwriting assumptions. If the deal outperforms expectations, and in actuality, generates 25% returns, the common equity investors get to share in that additional upside. The senior debt, mezzanine debt, and preferred equity investors have no claim to those additional revenues.
Of course, the downside risk is also much higher for common equity investors. Common equity investors have the most to lose if a property does not perform as anticipated. Because they hold the lowest-priority position within the capital stack, common equity investors may see no return on their investment (or repayment of their investment at all) if something goes catastrophically wrong and the other lenders/preferred equity providers need to be paid out first.
Common equity investors generally include private equity, REITs, pension funds, sovereign wealth funds and individuals. Those who invest in common equity are generally willing to take on more risk in exchange for substantially higher returns.
Why does the capital stack matter?
The capital stack is important for two reasons. First, from the sponsor’s perspective, how the capital stack is structured will influence a deal’s overall profitability. For example, a highly-levered asset that performs well will generate higher returns for equity investors. Conversely, an otherwise attractive investment might be ruined if the wrong combination of debt and equity is utilized.
From an investor’s perspective, understanding the capital stack is critically important, particularly as an investor tries to determine where to invest. Those seeking “safer” investments at lower yields might want to invest in low-leverage debt compared to those chasing higher yields, who may instead want to invest in common equity. Having knowledge of the source and type of capital used to finance any transaction will help individual investors determine how likely they are to be repaid in both upside and downside scenarios.
Capital stack real estate - which type is the most secure?
In commercial real estate, senior debt is considered the most secure position in the capital stack. This is because senior debt is secured by the asset against which the loan is being made. The lender will record a lien on the property until the debt is repaid (plus interest). If the borrower defaults on the loan, the senior debtor has the ability to make a claim against all cash flows and sales proceeds until they are repaid. In a worst-case scenario, a lender will assume ownership of the property (via foreclosure or otherwise) to cover their losses.
Mezzanine debt, which holds the second position in the capital stack, can also be secured by the property. However, this is not always the case. Some mezzanine loans are unsecured, which makes the investment somewhat riskier than investing in senior debt which is secured by the physical asset.
Capital stack real estate - which type is the least secure?
Equity, both preferred equity and common equity, is the least secure of all capital stack investments. Neither is secured by the asset. If a property drastically underperforms, the senior lender has the ability to take back the asset and recover its losses first. Only after the senior debt is repaid, and any subsequent debt, will the equity investors be repaid. In some cases, preferred equity might be repaid only in part. Sometimes, neither preferred equity nor common equity is repaid at all.
Most agreements are written so as to require a sponsor to repay its debtors first. Assuming the lenders have been repaid, the preferred equity investors may have the right to assume ownership of the property. Under new ownership, the preferred equity investors may be able to turn it around, in which case, common equity investors may be repaid some portion of their original investment (with or without interest). Therefore, common equity is the least secure of all positions in the capital stack and these investors have the most to lose if a sponsor does not execute according to plan.
Commercial capital stack real estate
Let’s consider how the structure of a capital stack can influence the profitability of a commercial real estate deal. Let’s say a sponsor is looking to purchase an office building that is leased to a single tenant that has a near-term lease maturity. That tenant has not yet indicated whether they plan to renew the lease or not. If the sponsor purchases the property at an aggressive price with a high-leverage capital stack, and then the tenant vacates, the common equity investors’ capital would suddenly be at risk. If the sponsor does not have a backup plan for re-leasing the property quickly, they could face a capital crunch that puts them in default of their senior loan obligations. Depending on the condition of the property, the sponsor may need to make capital improvements or other investments (which come at a cost) prior to releasing the property. Conversely, if that property were purchased using a low-leverage capital stack (i.e., more common equity), then they would have more built-in flexibility in the event of cash flow disruptions.
Multifamily capital stack real estate
The real estate capital stack is equally important relative to multifamily investments. Let’s say a sponsor is looking to purchase a low-risk investment, such as a well-located, stabilized apartment building. Taking on leverage allows sponsors to be more competitive with their offers, which is increasingly necessary in today’s low cap rate environment. A sponsor who is unwilling to take on leverage—i..e, senior debt—likely will not win the deal. Moreover, assuming appropriate leverage on a high-quality asset is a way to enhance the returns and tax benefits associated with the deal. Of course, sponsors must determine what “appropriate leverage” means for each specific deal.
Anyone who is considering an investment in commercial real estate will want to evaluate each opportunity carefully. Look at how much debt and equity are being utilized for each deal. Determine whether the balance of capital sources seems appropriate for the business plan the sponsor has put forward. Ultimately, be wary of investing alongside a sponsor who assumes significant leverage and does not have a robust track record of execution. Highly-levered deals are often the first to experience distress during an economic downturn, which puts common equity investors’ capital at the greatest risk.
Of course, any investment should be made in the context of an investor’s risk tolerance and time horizon.
Interested in learning more about Rising’s approach to structuring capital stacks for deals? Contact us today.
Chris Rising manages the day-to-day business activities of Rising, while also serving on its Investment Committee.
He received his J.D. Law, Real Estate from Loyola Law School and his B.A. in History and Political Science from Duke University.