Capital Stack

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Real Estate Capital Stack

I am often amazed at how many time I use the term “Capital Stack” only to have someone stop me and ask me to explain what I mean, so I thought I would take a few minutes to explain why this is important in analysis of real estate investments.

In its’ simplest form, the "Capital Stack" is the definition of one’s place in an investment. The "Capital Stack" refers to the legal organization of all of the capital placed into an investment. The Capital Stack determines who has legal rights to certain assets and income, who receives priority of payment in the event of an uncured default, and in which order each party may be repaid or given authority to take over or liquidate assets in the event of a bankruptcy.

Another way to look at it is – who has the most to lose? The Capital Stack not only defines legal rights but also is a way of assessing the risk one takes making the investment. Your place in the Capital Stack can make all the difference between a complete loss and full recovery of your investment on those rainy days when things go wrong.

The graph below show a typical Capital Stack formation in a commercial real estate deal.

Equity

Preferred Equity

Mezzanine Financing

2nd Lien Positions

1st Lien Positions

Taxes

Starting from the bottom, Taxes typically have the highest priority and in the event of a total loss, taxes would get any proceeds if any were available. This is one of the reasons that many people like to invest in tax liens because regardless of the debt, the taxes ultimately get paid or you get the asset.

Next up are 1st mortgages. If the 1st mortgage is say 60% of the investment, then the property would need to lose 40% of its value before the 1st Lien holders would sustain a loss (assuming the taxes are current). Since this type of 1st Lien is somewhat protected, the 1st lien investor usually gets the lowest overall return. (i.e. lowest risk)

As you move up the Capital Stack, each investment group is less protected, hence greater risk, hence higher return expectations. At the top, Equity has the greatest risk and hence the highest expectation.

All this seems very basic but far too often investors forget to take into account the level at which they are investing and the appropriate risk. To best highlight this I like to use a Band of Investment Approach to compare investments. Below is a simple Band of Investment analysis for a $1,000,000 property:

Investment A

Investment Class	Amount	% of Investment		Desired Return	Cap. Rate Allocated to Class
Equity	200,000	20%	X	10%	2%
Debt	800,000	80%	X	5%	4%
Indicated Capitalization Rate					6%

Now let’s look at the same investment with much less debt because the 1st Lien lender is not willing to move up to the 80% level in the Capital Stack. The resulting analysis might look like this:

Investment B

Investment Class	Amount	% of Investment		Desired Return	Cap. Rate Allocated to Class
Equity	500,000	50%	X	10%	5%
Debt	500,000	50%	X	4%	2%
Indicated Capitalization Rate					7%

As you can see, this analysis assumes that you are only interested in getting a 10% return to your invested dollars regardless of the risk. The debt has reduced the 1st lien investor’s desired return since they now have moved down the Capital Stack and reduces their risk.

The question is which is the riskier investment? A or B

Capitalization analysis would tell you that since B has a 7% cap. rate, B is the riskier investment.

A better answer might lie in the following:

Investment Class	Amount	% of Investment		Desired Return	Cap.Rate Allocated to Class
Equity	200,000	20%	X	10%	2%
Mezz. Position	300,000	30%	X	7%	2.1%
Debt	500,000	50%	X	4%	2%
Indicated Capitalization Rate					6.1%

Doing a little reverse math, the above analysis would indicate that for Investment B above, as an investor, you should be willing to accept less return for Investment B because part of your investment now is represented by your Mezz. Position.

Application of the Capital Stack in Investment Decision Making require an investor to establish their risk/reward equation first. Many of the investment structures in the middle of the Capital Stack have gradations of higher return with each level of additional risk.

The Capital Stack analysis can be segregated into many different investment classes. It is important that an investor understand how conditions such as recourse debt, environmental risk, property condition, etc… impact their position in the Capital Stack. At one extreme, an investor purchasing a single family rental with full personal recourse debt represents little difference from an all cash buyer since his/her investment represent the entire Capital Stack.

For more information and comments, please feel free to contact me at [email protected]

Nicolas Paez