By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
First, let’s define what a capital stack is. Pertaining to commercial real estate, a capital stack refers to the differing layers of money resources that are involved in buying and improving a project having to do with real estate. The differing layers have to do with the amount of risk in the investment end of the commercial real estate deal.
The level at the bottom is the least risky level and it therefore has a low return on investment. Each level moving upward has higher risk and higher return. Starting from the bottom, a capital stack most often has senior debt, mezzanine debt, preferred equity, and common equity. Common equity has the highest reward (return), but the highest level of risk.
If you are a commercial real estate investor and want to invest in a capital stack, it is of utmost importance that you do due diligence for where in the stack you want to invest. The capital stack gives you the ability to see a stack of investment choices arranged from the bottom to the top. The bottom level being the least risky with the lowest return to the top level with the most risk, yet the highest return.
A major factor in choosing which level of debt an investor wants to commit to is that the higher you go in the stack, the less likely it is that the debt will be paid off. The top level of the capital stack is least likely to be paid off. All other layers get paid off first. The order of payoff is from the bottom upward. The first level gets paid off first, the second level next, and so on.
At the bottom level there is secure debt which means the debt is collateralized. Thus, if there is a foreclosure on the property, there is collateral to pay off the loan. This makes the bottom level of the stack a low risk investment. But low risk means low return on investment.
You need to determine what your risk level is. For example, if you are fairly young with a high income, savings, and low debt, your risk level is probably going to be considerably higher than an investor who is 65 years old and living off of retirement income.
Understanding the capital stack is so important when it comes to prudent investment. To not understand it is truly risky because you don’t understand what you are getting into.
Some investors mitigate the level of risk by investing in two or more levels of the stack. Thus levels that perform poorly may be balanced out by levels that perform better.
Here is the order a capital stack is frequently arranged in from the top down:
1. Common Equity
This level is at the top of the stack and therefore has the most risk. At this level, the investor has an ownership stake concerning the property. Again, this level has the highest amount of risk, because if you are an owner, you get repaid only after all the other levels in the stack are paid off. On the other hand this level has the highest amount of return.
2. Preferred Equity
This form is the next level down the capital stack, and it is another form of equity in the project. It is senior to common equity, but it has a lesser priority to debt. Those investors who have preferred debt have the advantage over common equity holders of getting prioritized payments before those who hold common equity. Preferred equity holders also get a percentage share of the capital gain total involved in the project. Due to it having seniority to common equity, the risk and upside for the preferred equity holder is a little less than that of the common equity holder.
3. Mezzanine Debt
When it comes to the capital stack, the next level down is Mezzanine debt. It is the first form of debt in the capital stack. This level and also the preferred equity level are thought of as being a hybrid structure. This is because it has seniority to equity levels in the capital stack, but at the same time it is a level that is subordinate to the senior debt level.
Those who hold mezzanine debt want a rate of return that is greater than those who hold senior debt. This is because their position is unsecured. The only way mezzanine debt gets repaid is if all senior debt is paid off beforehand. Because it is a kind of a hybrid, mezzanine debt holders typically are paid interest payments periodically. Also, there is the potential for more earnings in a small shared interest that is in accrued interest that is additional or in future upside.
4. Senior Debt
Senior debt is at the base of the stack. It is the foundation. Most of the time it is the majority of the stack. Also, most of the time it is collateralized by the property itself. Because it is secured by the property, it typically has the lowest level of risk.
Those who are the holders of senior debt, by contract get interest payments that are ongoing, prior to investors getting return who occupy levels that are higher in the stack.
Note that the example above illustrates four levels of a capital stack. But, a capital stack could have even five or more levels of stack, depending on those who formulate the capital stack. Again, because there is higher security in senior debt, when the interest payments are established, it has the a lower level of return than all the other levels.