The Commercial Real Estate Capital Stack

[Greg Barrett]

The capital stack relates to the layers of investment financing for a real estate deal. The capital stack creates a visual representation that helps investors understand where they fall in terms of the priority of repayment and where the stand on the risk premium continuum.

Most real estate investments are financed through a combination of debt and equity. Typically, the sponsor of the deal will contribute equity, as will a number of limited partner investors. The equity raised between the sponsor and investors will typically be between 30% to 45% of the capitalized value (Purchase Price + Acquisition Costs). The sponsor will secure debt to cover the remainder of the capitalized value; typically between 55%-70%. A capital stack with just two layers--common equity and senior debt--is the most common financing structure. This capital structure is typical when investing in stable assets. See the figure below outlining a typical debt and equity financing structure.

The capital stack becomes more complex--with added layers--when the project becomes more nuanced. Value add projects--where the sponsor intends to renovate the property--or more risky investments may require another layer or two added to the capital stack. In these types of investments, the senior lender typically doesn't want to loan the amount needed to cover the construction costs; therefore, a gap between the senior note and the common equity exists. This is when the sponsor will seek to obtain preferred equity or mezzanine debt. See the below figure.

Below I break down the common layers of the capital stack. Note that there is no limit on the layers of the capital stack for a given project; however, the four layers below are the most widely used in commercial real estate.

Common Equity

Common equity sits at the top of the capital stack. As indicated in the image above, common equity sits higher on the risk premium continuum--meaning that their investment is at greatest risk in the event that the investment doesn't turn our as expected. This means that common equity investors will be paid last. However, being at the highest position means that the returns could be the greatest. Due to assuming added risk, equity investors will benefit the most from the upside. If the property generates strong cashflow and appreciates over the life of the investment, then equity investors will stand to benefit more than the debt investors. Typically the upside is uncapped.

Repayment Priority: Last

Risk Profile: Highest

Potential Returns: 10%+

Preferred Equity

Preferred equity sits in between common equity and debt; it is a debt/equity hybrid. Therefore, preferred equity holders require a higher rate of return than debt holders, but a lower return than common equity holders. Preferred equity will generally have a hurdle rate--which means that the preferred equity holders must achieve a predetermined return before common equity holders get paid. Preferred equity has a hybrid risk/return profile. In some cases the preferred equity holders may have recourse in the event that the borrower defaults.

Repayment Priority: Third

Risk Profile: Medium - High

Potential Returns: 7-10% +

Mezzanine (subordinate) Debt

Mezzanine Debt is very similar to preferred equity as it is also a debt/equity hybrid. The main difference is that Mezzanine financing is a form of debt that can be converted to equity in the even the borrower defaults, whereas preferred equity is a direct ownership stake in the property. Mezzanine debt is typically used when the developer needs to fill a gap between senior debt and equity. Mezzanine debt sits in between equity and senior debt on the capital stack. Mezz debt is subordinate to senior debt--which is a fancy way of saying that they get paid after the senior debt holders. However, mezzanine debt holders have payment priority over all equity positions (preferred equity and common equity). As such, they typically receive a rate of return lower than preferred equity holders but greater than senior debt holders. It's typically a flat rate of return similar and does not participate in the upside.

Repayment Priority: Second

Risk Profile: Medium - High

Potential Returns: 10-20%

Senior Debt

This is the most secure position in the capital stack--which is why it sits at the foundation. Senior debt gets paid first until fully repaid. In other words, the interest on the debt gets paid before mezzanine debt and before equity investors receive a return. Therefore, if the investment were to fail then the senior debt position is the best place to be. The other benefit of being a lender in the senior debt position, is that they typically have the right to take back the property (become the owner) in the event of a default. The downside to this position is that the senior debtholder will not participate in the upside. They typically receive a flat rate of return (aka as fixed coupon or interest). Even if the investment is a grand slam, the debt investor will only achieve the interest rate stipulated in the loan documents.

Repayment Priority: First

Risk Profile: Low

Potential Returns: 3-8%

Conclusion

Commercial real estate offers investors a wide array of positions in the capital stack to help investors achieve their objectives. Some investors prefer to only invest in the common equity position because they seek outsized returns. Others prefer the preferred equity or mezzanine debt position. Banks and other financial institutions with ample cash prefer to be the lender (senior debt) due to the security of being in the first position, the ability to take back the property, and the predictability of interest payments. Understanding the risks and rewards of each position in the capital stack is crucial to understand before investing.