The Capital Stack (capital structure) describes all of the financial instruments used for the debt and equity of a commercial real estate transaction.
In this article, we will be discussing the Capital Stack, and how it works with commercial real estate.
Intro to the Capital Stack
The Capital Stack describes all of the financial instruments used for the debt and equity of a commercial real estate transaction. It can be very ‘simple’ with Senior Debt at 80% of the value, with 20% of Equity. It also can be more complex… ‘a full stack’ which can include Senior Debt (First Trust Deed Lender), Mezzanine Debt, Preferred Equity, and Common Equity.
Senior Debt
We all know about a traditional mortgage which is the same as Senior Debt. This is the most risk-aversion position in the capital stack. The Senior Lender, (Ie Fannie Mae, Freddie Mac, etc.) typically lends up to 70-80% of the value of the acquisition. The Senior Debt is in first position of the capital stack which means they have first priority in payment. Because of this, they achieve the least amount of risk, and the least amount of return. In the case of the borrower’s default, the Senior Lender will take over the operating position of the asset.
Mezzanine Debt
Mezzanine debt, which sits behind the Senior debt in terms of payment priority, offers a ‘financial bridge’ between the senior debt, and equity. Mezzanine Debt is typically shorter term and offers debt 5-20% of the value or cost of the investment. Because of its position in the capital structure, and priority above the equity, there is less risk but still has a cap on the return.
Preferred Equity
Preferred Equity, which is subordinate to Mezzanine Debt and has priority over Common Equity (‘Preferred’) is very flexible compared to Mezzanine in a sense that it can have a fixed rate and/or upside potential. Preferred equity offers a fixed rate of return and can differ for each deal and operator. Preferred equity and Common Equity can also be shared, which might be structured to offer a ‘Preferred Rate’ with a hurdle (Ie 8%) then is split within the waterfall (Ie 70% to Investors).
Preferred Equity has priority over common equity, so depending on its structure, Preferred Equity could have less risk than Common Equity and capped upside potential.
Common Equity
Common Equity, which sits at the top of the Capital Stack, is considered to be at the most risk within the structure because its position is subordinate to all other tranches of capital, and therefore, has the potential for the highest returns. Senior Lenders require equity or ‘skin in the game’ from the General Partner (sponsor or operator) which is also Common Equity.
In real estate, common equity investors will typically receive a ‘Preferred Rate’ with a hurdle (Ie 8%) which is structured within what’s called, ‘The Waterfall’. After the hurdle, the sponsor or operator will receive a disproportionate share of the rest of the profits (Ie 40%). This is called the ‘Sponsors Promote’.
Though Common Equity is situated at the top of the capital structure and is considered at the most risk with the most upside potential, not all common equity investments are created equal as it relates to the risk/return profile. A healthy preferred rate of return can also offer investors downside protection.
Conclusion
Understanding the different structures across the Capital Stack is critical in making Commercial Real Estate a part of your portfolio. How you allocate between debt and equity should depend on your investment goals, risk-tolerance, and strategy, and will depend on the timing of the current cycle.
As of writing this, the credit market has been extremely favorable throughout the past few years. When credit becomes tight, opportunities for passive investors open up in other parts of the capital structure.
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