Capital Stack Guide

By PropertyClub Team
Jun 17th 2022
Real estate financing can often get quite complex, and developers often need multiple sources of capital to fund a project and manage the risk. These different layers of funding are then organized in what is known as a capital stack to show investors and other key decision-makers the structuring of the debt and equity. Understanding the capital stack is critical to a successful career as a real estate investor or developer. So, here is a closer look at this crucial concept.

hash-markWhat Does Capital Stack Mean?

A capital stack outlines the different layers of capital that go into financing a commercial real estate project. Investors can contribute capital in two different ways – debt or equity. Debt financing means the lender must be repaid with interest, while equity means the investor owns shares in the investment.

The capital stack will track who invested what and what type of financing they contributed. It will also state how much each investor will earn in the property's income and profits and who is paid first. So, the capital stack is necessary to determine who is financing the project and the potential risks and returns of each layer.

hash-markCapital Stack Order Priority 

The capital stack features four layers; senior debt, mezzanine debt, preferred equity, and common equity. These layers are then positioned – or stacked – in order of priority based on the amount of associated risk. Senior debt is at the bottom, followed by preferred mezzanine debt, preferred equity, and common equity at the top.

The higher the level, the higher the risk and the higher the potential returns. Returns generated from the investment will be distributed from the bottom up. The debt levels must be paid first, and any excess revenue will flow to the equity levels.

hash-mark4 Layers of Capital in Capital Stack Funding 

Senior Debt

The senior debt level is the top priority and will be repaid before any of the other levels in the capital stack. Senior debt is typically held by a bank or other institutional lender who issues the mortgage and may reclaim the underlying asset if the equity owner defaults on the loan. Senior debt typically finances the majority of the project, although it varies. 

Mezzanine Debt

Mezzanine debt is the next in the pecking order and refers to financing from a bank or private lender that is at higher risk than senior debt but also carries a higher interest rate. In the event of a default, lenders can convert mezzanine debt into equity since the lenders at the senior debt level have a right to reclaim the property. 

Preferred Equity

Preferred equity typically refers to the equity layer given priority over common equity, but definitions have changed slightly over the years. In some cases, it functions like debt with a fixed return but gives investors greater ability to take over the project in the event of a default. 

Common Equity

Common equity is the highest risk position in the capital stack. It typically comes from the developer or sponsors responsible for the daily operations of the investment and any other private investors they recruit. They are the last ones paid after all the other levels have recouped their investment, but if everything is a success, they can often make the highest returns. 

hash-markCapital Stack Example

Say you are planning to develop a commercial real estate project that costs $15 million to purchase and an additional $5 million to develop – bringing the total to $20 million. Here's an example of what the capital stack might look like:

Layer

Amount

%

Common Equity

$4 Million

20%

Preferred Equity

$3 Million

15%

Mezzanine Debt

$3 Million

15%

Senior Debt

$10 Million

50%

The exact percentages and amounts will vary from project to project, but this is generally what a capital stack will look like – with the majority financed by senior debt and the rest split amongst other lenders or private investors with varying degrees of risk.

hash-markWhy is Capital Stack Important? 

The capital stack allows investors to get a clear picture of how the financing is structured, which is crucial for analyzing the risk level of each layer. It establishes who will receive a return first and who has a right to the asset if the equity holder default on the loan – so that everyone is on the same page from day one.

Investors can use the capital stack to analyze the investment and determine how much risk they are willing to take on. The capital stack essentially sets the financial ground rules for the investment, so it's crucial for anyone involved in the project to have a thorough understanding of how it's structured.  

hash-markCapital Stack Bottom Line 

The capital stack is essential for all developers and commercial real estate investors to understand. If you're interested in getting into the development business, you must study this concept closely and understand each layer's potential risks and returns. This understanding will allow you to assess your own risks and make smarter decisions about where to put your money.