When diving into commercial real estate investing, one of the foundational concepts you'll encounter is the capital stack. This term may sound like financial jargon, but it’s really a pretty simple concept: the capital stack is the combined layers of debt and equity that fund the purchase of a property. And understanding it is crucial to assessing potential risks, rewards, and your role in a deal.
Whether you're investing in retail properties, office buildings, or industrial assets, the capital stack provides a framework for how money flows in and out of a project.
Knowing the stack helps you align with an investment strategy that suits your risk tolerance. Whether you are looking for stable, predictable returns or want to venture into the unknown, there is an option in the capital stack if you know how to identify it.
In this article, we’ll break down the capital stack, its four major components, why it’s important for investors to understand, and how it influences decision-making in commercial real estate investing.
What is the Capital Stack?
The capital stack is the hierarchy of funding sources used to finance a real estate project. It shows who gets paid first, bears the most risk, and enjoys the highest potential returns.
It’s essentially a layered structure that shows who gets paid and in what order. Each layer comes with its own level of risk and reward. Broadly, the capital stack is divided into debt and equity categories.
Broadly, the capital stack is divided into debt and equity categories:
- Debt: capital borrowed from banks or investors to fund a project
- Equity: capital secured through investors buying a company’s stock
Imagine a towering skyscraper, where each floor represents a different investment risk and return level. At the very bottom, you have the foundation (senior debt), which is the most stable concrete base of the building. This is the bank's loan, solid and secure, with the first claim on any returns.
Moving up, you'll find the mezzanine debt, like the sturdy steel beams connecting the foundation to the upper levels. It's a bit more flexible but still critical to the structure's stability. These investors have a slightly higher risk tolerance and expect a bit more return for their additional risk.
You have common equity at the top of the skyscraper - the penthouse investors. These are the risk-takers, the visionaries who stand to gain the most if the building (or investment) performs exceptionally well. They're also the first to absorb losses if things go wrong, but they have the potential for the most significant returns.
Like in a skyscraper, each level of the capital stack plays a crucial role. The lower levels provide stability and fundamental support, while the upper levels provide the vision and potential for extraordinary gains. Everyone benefits if the building (investment) performs well, but the rewards are distributed differently based on where you stand in the stack.
Each layer comes with its own level of risk and return, which we'll explore in detail. We will start at the bottom with the lowest risk and make our way up to the highest.
To illustrate:
Each layer comes with its own level of risk and return, which we'll explore in detail. We will start at the bottom with the lowest risk and make our way up to the highest.
Main Components of the Capital Stack
1. Senior Debt: The Base Layer
Senior debt is the most secure form of financing. Typically provided by banks or institutional lenders, senior debt is a loan backed by the property itself. Senor debt normally has the lowest risk and the lowest return on investment, with a typical return range of 4% to 7%.
This is one of the more secure financing options because senior debt holders are the first to get paid if the property generates income or is sold. In case of a default, they can foreclose on the property.
Example in Action: For a shopping center with a $10 million value, a bank (typically the entity that funds senior debt) might lend $6 million as senior debt, requiring the remaining $4 million to come from other sources. If the property generates income, the bank receives its payments first, ensuring consistent returns.
2. Mezzanine Debt: Bridging the Gap
Mezzanine debt acts as a middle ground between debt and equity. These lenders are next in line for repayment after senior debt holders.
This option has moderate risk and moderate returns, with investment returns usually ranging from 8% to 20%. If the project fails, mezzanine debt holders are only repaid after settling senior debt. Interest rates here are higher than senior debt due to the increased risk.
Example in Action: Continuing with the $10 million shopping center example, a mezzanine lender might step in if $2 million is needed to bridge the gap after senior debt. Their agreement might include a fixed 10% interest rate plus a small percentage of any profits if the property performs well.
3. Preferred Equity: A Steady Slice
Preferred equity investors contribute funds in exchange for a fixed return or preferential payment rights before common equity holders.
This type of capital has a higher risk and return than mezzanine debt, with a general return range of 10% to 15%. The increased risk comes from investors having no claim to the property, and the higher return is because they may still negotiate payment guarantees or minimum returns.
Example in Action: An investor might contribute $1 million as preferred equity to the shopping center project, earning a guaranteed 12% annual return. Even if the property underperforms, preferred equity holders get paid before common equity investors see profits.
4. Common Equity: The Top Layer
This part is where the sponsors and other equity investors come in. Common equity holders have the greatest potential upside but take on the most risk. They get paid last, after all debts and preferred equity obligations are satisfied. However, they typically share in the project's profits, which is why they potentially have the biggest returns, with returns often ranging from 15% to 30% or more.
Example in Action: After securing $6 million in senior debt, $2 million in mezzanine debt, and $1 million in preferred equity, the remaining $1 million needed for the shopping center project might come from common equity. These investors could see 15% to 30% returns if the property performs well but risk losing their entire investment if the project fails.
Balancing Leverage in the Capital Stack
When crafting their strategy with their capital stack’s structure, institutional investing partners must determine what balance they want to create between debt and equity. While the four main components make up the capital stack, the distribution of each category depends entirely on how much equity and debt the partner is aiming for.
The amount of money borrowed (debt) is directly tied to the risk of an investment. So if the capital stack comprises 80% debt (money borrowed from the bank) and only 20% equity, investors have greater returns, as fewer people also need to get “their piece” of the ROI. On the other hand, with more debt, there are greater risks if an investment goes sour, and the banks can seize the property to cover the loan they gave, leaving investors with nothing.
The agreement is considered highly leveraged whenever a deal has more debt than equity in the capital stack. Leverage is when the partners use borrowed money to complete a deal, meaning the more borrowed money involved, the higher the leverage.
Balancing debt and equity in the capital stack requires careful analysis, conservative underwriting, and a keen understanding of market dynamics. As an investor, ensuring that your institutional partner properly balances debt and equity in a way you are comfortable with for your investing needs is vital.
Why Investors Should Understand Capital Stacks
The capital stack isn’t just about organizing finances—it plays a critical role in how risk and reward are distributed in a deal. Here’s why it matters:
- Understanding Your Position: Are you investing as a common equity partner or purchasing mezzanine debt? Your position in the stack affects your potential returns and your risk exposure.
- Evaluating Risk: The lower your position in the stack, the lower your risk. Senior debt investors face less risk than common equity holders, who are at the mercy of market conditions and project success.
- Negotiating Returns: Knowing the capital stack allows you to negotiate terms that align with your investment goals. For example, a risk-averse investor might prefer mezzanine debt for stable returns, while a risk-tolerant investor might pursue common equity for a higher upside.
How Investors Choose Their Place in the Capital Stack
Investors often wonder if they have control over where their money goes in the capital stack and how much risk they take on. The good news is that, in many cases, you can choose your position and align your investment with your risk tolerance. However, your level of control depends on the investment structure you’re participating in. Let’s explore the factors that influence this decision.
1. Choosing Your Component in the Capital Stack
When investing in a real estate project, you can typically decide whether to contribute as part of the debt or equity side of the capital stack. Here’s how this choice plays out:
Direct Investments
If you’re investing directly into a project, such as through a private loan or equity stake, you have more flexibility to choose your position. For example:
- Debt Investors: you may opt to lend money to the project, earning a fixed return through senior or mezzanine debt.
- Equity Investors: you may take an ownership stake, participating in the deal's profits (or losses).
Your choice will depend on your financial goals. Are you looking for a steady income and lower risk? Debt might be the way to go. Seeking higher returns and willing to accept greater risk? Equity is more appropriate.
Syndications and Funds
In a syndicated deal or real estate investment fund, sponsors often predefine the capital stack structure, offering investment opportunities at specific layers. For example:
- A syndicator might offer separate pools for preferred equity and common equity, allowing you to choose which layer aligns with your goals.
- Some funds cater specifically to debt or equity investors, narrowing your options based on their focus.
While you can’t usually customize the capital stack in these scenarios, you can select an investment that aligns with your preferred level of risk and return.
2. Can You Choose the Overall Risk Tolerance of the Capital Stack?
Evaluating the Risk of the Capital Stack
Before investing, take a close look at how the deal is structured:
- Leverage Ratio: A highly leveraged stack (e.g., senior and mezzanine debt comprising 80–90% of the funding) signals higher risk for equity investors. In contrast, a more balanced stack with significant equity contributions is generally safer.
- Sponsor Equity: The amount of equity the sponsor has contributed can indicate how much risk they’re willing to take. If the sponsor has significant “skin in the game,” it’s a good sign they’re incentivized to ensure the project’s success.
Participating in Risk-Managed Deals
Investors can also seek out deals with a capital stack designed to mitigate risk. For instance:
- Some sponsors intentionally limit the use of debt to create a more conservative structure.
- Others may secure preferred equity investors to protect common equity holders by adding a buffer against potential losses.
While you may not always control the capital stack's overall structure, you can choose where your contribution fits and the level of risk you’re comfortable taking. By assessing the stack carefully and understanding the dynamics of each layer, you can make informed decisions that align with your financial goals.
Capital Stacks as a Strategic Investing Tool
While it might be easy to dismiss the capital stack as just another financial structure at first glance, looking at it more closely, you will find that it is more: it’s a roadmap for understanding how risks and rewards are shared in a commercial real estate investment. Knowing where you stand in the stack and how it aligns with your investment strategy allows you to make informed decisions that maximize your returns while managing risks effectively.
Whether you’re looking to invest in a single retail property or a larger portfolio of shopping centers, mastering the capital stack will give you the confidence to navigate the world of commercial real estate investing.
Now that you understand the basics of the capital stack, use this knowledge to ensure that a project’s structure fits your needs before investing. Always ask about the capital stack when evaluating an investment. Where does your money fit in, and how does it affect your risk?
Remember, the better you understand commercial real estate concepts, the better positioned you are to evaluate whether or not a company is equipped to manage and grow your investment properly.
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