The Capital Stack and Debt & Equity Financing

[Patrick O'Donnell]

Hello,

This is my first post, it's meant to be a post on the basics of the capital stack and the advantages and disadvantages of equity financing...I figured this would be the appropriate sub-forum to post this in.

Capital stacks can come in many forms, the simplest being 100% equity or 100% debt. The typical capital stack comes with a mixture of both debt and equity financing, and even hybrid debt often referred to as mezzanine financing. It’s generally visualized as a pyramid or tall rectangle categorized by risk. The bottom or foundation of a capital stack is usually where you find debt. This bottom position, like a 1st mortgage, represents the lowest risk and lowest potential returns in the capital stack. In case of default these parties in lower positions on the capital stack will be paid first. Likewise as you go up the capital stack you will encounter other types of debt eg. second mortgages, mezzanine financing like bridge loans, preferred equity, and finally common equity. The higher your position in a capital stack the higher potential returns. The 1st mortgage may only be getting 10% in interest but equity owners can realize unlimited returns as well as unlimited losses.

Many investors have different preferences, goals, and strategies. Some capital stacks will be heavy debt with the first 70% of the capital stack coming from a 1st mortgage. An investor might need more financing for their project so they will assume some more debt in the form of mezzanine financing. This second position in the capital stack will require higher interest because these creditors will assume more risk. Mezzanine financing is often referred to as the gap between debt and equity. Preferred equity on the other hand is a type of “hybrid” debt/equity, it’s less secure than both junior and senior debt but more secure than common equity.

The capital structure of a real estate investment can have many intricacies. Each party to an investment has different interests with the same intentions to realize some sort of gain whether they are risk averse or risk tolerant.

Investors might prefer equity financing for some distinct advantages. First off, the parties to a pure equity investment hold the investment “free and clear” of debt or obligations to banks, creditors, and other parties. This can be advantageous especially during market downturns as the investors have no obligation to pay other entities. It’s a type of security blanket for sure, the only loss to the investor is the time it takes for the market to recover. Another advantage is the idea that you aren’t siphoning off money (cashflows), which could be used in other operations, like covering debt servicing. This is especially important to entrepreneurs looking to grow start-up businesses. The idea is that you want to use the cash to grow the business faster. There are some disadvantages to equity financing. Investors financing with projects with some sort of leverage may find that they can grow their annualized returns higher than equity financing. To the start-up company, giving up equity can be unappealing especially if the entrepreneur has a vision of the company growing exponentially. In any form of business whether it be real estate investing or growing start-up companies, investors and entrepreneurs have to balance the pros and cons of these 2 types of financing methods to tailor their own needs.

Sources:

http://www.jrwinvestments.com/articles/principles-of-wealth-management/understanding-the-capital-stack-and-how-it-affects-your-investments/

http://www.nfib.com/article/ital-50036/