Table of Contents
What Does Capital Stack Mean?
Layers of Capital Stack Funding
Capital Stack Order Priority
Capital Stack Example
Why Is Capital Stack Important?
Capital Stack Bottom Line
What 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 return for either debt or equity. The capital stack will track all the investments made and also state how much each investor will earn in the property's income and profits and who is paid first.
The capital stack is important as it helps track who is financing the project as well as the terms of the financing. If an investor puts money into a debt financing round, they will be repaid with interest and will typically be repaid before investors that are contributing money for equity.
Layers of Capital Stack Funding
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
1. 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.
2. 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.
3. 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.
4. 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.
Capital 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.
Capital 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.
Why 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.
Capital 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.