Understanding the Capital Stack: A Simple Guide for Investors

I get asked almost daily about investment distributions, the risk vs. reward, and the timelines of different commercial real estate (CRE) investments. Understanding the capital stack is essential for investors looking to diversify their portfolios through syndications and funds. It surprises me how many people who work in real estate have no idea or understanding of the capital stack. The capital stack is the way a big project gets funded and structures who gets paid when. It is represented in a picture by a layered structure of financial contributions from various sources, each with its own level of risk and return. This guide aims to simplify the capital stack, offering insight into its components and the implications for investors in syndications and funds.

What is the Capital Stack?

The “capital stack” is actually just a visual representation of the hierarchy of claims to the cash flows and assets of a real estate investment. It's arranged from the most secure investments (primary debt/1st lien position) at the bottom to the riskiest at the top (common equity). Understanding this structure is critical for investors, as it directly impacts the potential returns and risks associated with their investment. Above is an image representing the capital stack.

Components of the Capital Stack

1. Senior Debt

At the foundation/bottom of the capital stack is the senior debt, AKA primary debt or 1st lien position, which is usually the largest portion of the financing in a commercial real estate deal. Senior debt is secured by the property itself, making it the least risky investment. Lenders have the first claim on the property's income and, in the event of default, the property itself. Interest rates on senior debt are typically the lowest among the layers of the capital stack, reflecting its lower risk. The senior debt is usually coming from a bank as a mortgage.

2. Mezzanine Debt

The next layer on the stack above senior debt is mezzanine debt, which can be a hybrid of debt and equity financing or just one. Mezzanine lenders generally have a secondary claim on the property's assets and income, subordinate to senior lenders, you can think of this as a second mortgage. Sometimes it is called a “bridge loan”. This layer often involves higher interest rates which is a bigger return for the investor due to its increased risk. In some cases, mezzanine debt may include an equity component, offering lenders the option to convert their debt into equity. The financing can come from a bank, but it usually comes from private investors.

3. Preferred Equity

Preferred equity is a step above mezzanine debt and offers a fixed return similar to debt but is treated as equity in the capital structure. It is privately funded by investors. Preferred equity holders have priority over common equity investors in cash flow distribution and, in some cases, may have a capped return on investment. This layer offers a balance between risk and reward, providing a safer investment than common equity while potentially offering higher returns than mezzanine debt. As the risk grows on the capital invested the returns should be higher.

4. Common Equity

At the top of the capital stack is common equity. Common equity investors have the last claim on cash flows and assets after all debts have been paid. While this layer carries the highest risk, it also offers the potential for the highest returns to investors, especially if the property appreciates in value or generates significant income. However, if the property doesn’t perform as expected this category of investors feels it the most.

Investing in Syndications and Funds

Syndications and real estate funds offer investors the opportunity to participate in the capital stack without needing to directly manage properties. Before investing investors should be aware of which layer of the capital stack they are investing in. Make sure you read the Private Placement Memorandum (PPM) to get a complete understanding of the risks involved in deals. It is important to consider your level of risk tolerance and investment goals. Syndications and funds can provide access to a diversified portfolio of real estate assets, spreading the risk and offering the potential for stable returns.

Understanding the capital stack is imperative for commercial real estate investors, especially those participating in syndications and funds. By recognizing the risks and returns associated with each layer, investors can make informed decisions that align with their investment strategy and goals. The capital stack adds a little more complexity to the diversity of investment options within real estate but also underscores the importance of risk assessment in achieving financial success. Reach out if you would like to discuss this in more detail.