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The capital stack is an important concept to understand for anyone looking to invest in real estate. In the simplest terms, it encompasses the total value of capital necessary for a project and what the expected return and priority of repayment is for that capital.
REAL ESTATE • IMPACT INVESTING • PRIVATE MARKETS
There are two main parts of any capital stack:
As expected, the higher risk capital such as equity will receive its capital last but is compensated for this risk with the highest return. Alternatively, the lowest risk part of the stack, debt, will receive its capital back first but has the lowest return.
Each of these parts can be broken down further to common equity, preferred equity, mezzanine debt and senior debt. Let’s dive into each of these further:
The Capital Stack
The senior debt holder has priority to receive capital back, including principal and interest, before any other parties are paid. This is the least risky position of the capital stack given the ability to take possession of a property if a borrower fails to pay their mortgage. In general, senior debt usually comprises 65-75% of the capital stack.
This is second lien debt on the property, which is debt that will be paid after the principal and interest of the senior debt holder has been paid in full. This occurs in the case of a sale, either by choice or through bankruptcy. Given its priority after the senior debt, and ultimately higher risk, its rate of return is higher than senior debt.
While structured slightly differently than mezzanine debt, preferred equity is functionally the same as mezzanine debt in that it pays a similar interest rate and is usually in second lien position.
In general, preferred equity or mezzanine debt comprises 10-20% of the capital stack. Developers or sponsors will utilize preferred equity or mezzanine debt to enhance the IRR of a project, given its ultimate cost is usually lower than that of common equity. Note that it is rare to have both mezzanine debt and preferred equity in the same capital stack, due to borrowers preferring the more streamlined deal structure that preferred equity allows for.
Common equity is comprised of contributions from both the sponsors or developers and their corresponding investment partners. It is the riskiest but potentially most profitable portion of the capital stack. Common equity holders are paid last, but get to participate in the ongoing cash flow distributions of the property along with the potential upside after the all-loan servicing obligations have been paid.
Benefits of Real Estate Investing
Income: Real estate can provide consistent income to underlying investors through the generation of cash flow from these properties.
Capital Appreciation: Real estate can appreciate in value as a result of local market appreciation, increased demand of the real estate asset, value-add investments, or the development of land.
Diversification: While real estate values are likely to be impacted by broader macroeconomic factors, in general, real estate has a low correlation to most major asset classes. This can lower total portfolio volatility over time.
Inflation Hedge: In general, inflation is a result of both GDP growth and the subsequent increased demand for real estate. Real estate can pass inflationary pressures to tenants through increasing rents.
Tax Benefits: Real estate investors can take advantage of the depreciation tax benefits of real estate, reducing taxable income from other income sources.
Drawbacks of Real Estate Investments
Illiquid: Real estate is illiquid which means that can take considerable time, effort and expense to sell an asset.
Influenced by Geographic Factors: Real estate is highly correlated to localized geographic factors including population growth, job growth, and increased supply of similar properties being built.
Large Initial Outlays: Real estate takes significant capital to purchase or build, necessitating significant capital at the front end of the investment.
Can Require Active Management & Expertise: In many cases, real estate will need to be actively managed which may take specialized expertise.
In any real estate deal, there are many factors to consider when evaluating potential risk and returns. It is also the case that the structure of the capital stack will vary from deal to deal. As such, it is important to understand the risk of the opportunity and if the expected return compensates the investor for that risk.
Learn about current investment opportunities in real estate by clicking here.
This communication and the information contained in this article are provided for general informational purposes only and should neither be construed nor intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice.
The Capital Stack encompasses the total value of capital necessary for a project and what the expected return and priority of repayment is for that capital.
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