It’s crucial that investors looking to evaluate the risks of direct real estate investments are familiar with more than just the capital stack definition. In commercial real estate, the capital stack refers to the various layers of financing. These layers contribute to funding the acquisition and improvement of a property.
Each layer represents a different source of capital, from senior debt to common equity, each with its own risk and return profile. Investors need to grasp the nuances of the capital stack in real estate to determine where they fall in the order of cash flows. Understanding this hierarchy helps them assess their repayment risk.
Components of Capital Stack
The majority of capital in the stack can be grouped into four categories: senior debt, mezzanine debt, preferred equity, and common equity.
Senior Debt:
Senior debt is the top priority in the capital structure, meaning these lenders get paid before any other investors. This usually includes the mortgage lender or another main debt holder with the most substantial claim on the asset. This position is the safest because if the borrower defaults, the lender can foreclose on the property and sell it to recover the loan.
To gauge the risk in commercial real estate investing, investors should look at the loan-to-value (LTV) ratio. The LTV shows how much debt is on a property compared to its value. A loan with 65 percent LTV is safer than one with 85 percent LTV. Lenders prefer to take over a property at 65 percent of its value rather than at 85 percent in case of foreclosure, as it helps them recover more of their capital.
Typically, senior debt makes up about 75 percent of the total project cost. However, this can vary depending on the building’s risk profile, the economic cycle, and the borrower’s credit history. This debt position is the most secure in the capital stack because it is backed by the property. However, this security usually means it has the lowest return compared to other positions in the capital stack.
Mezzanine Debt:
After all operating expenses and senior debt payments are covered, any leftover cash is used to pay mezzanine debt. This makes mezzanine debt second in line for payment right after senior debt. If there isn’t enough money to pay everyone, senior debt gets paid first, followed by mezzanine debt.
Mezzanine debt in the capital stack real estate is like a second mortgage or a Home Equity Line of Credit (HELOC) on the house. In both cases, the lender takes on more risk because the mezzanine debt is paid after the main loan. This extra risk usually means higher interest rates for mezzanine debt. For example, if senior debt interest rates are around 4-5%, mezzanine debt rates might be 8-12% to account for the higher risk.
In commercial real estate, mezzanine debt often comes with specific conditions and may include options to convert the debt into equity. If certain conditions are met, lenders can gain more than interest payments.
Preferred Equity:
Preferred equity has changed significantly in recent years and has become a less clear term in finance. Initially, it was similar to common equity but had better payment rights. Since the Global Financial Crisis, it has often acted more like subordinate debt, offering a fixed return. It also provides extra control if there’s a default but no profit sharing.
This shift happened because lenders realized that mezzanine lenders had more rights than expected during the Global Financial meltdown. This made it harder for primary lenders to recover their money when borrowers defaulted.
To prevent this, lenders began to ban second-position loans, like mezzanine debt. Preferred equity was then redesigned to fill this gap. Although it isn’t labeled as debt, it functions much like debt within limits set by first mortgage lenders.
Common Equity
Lenders often require developers or sponsors to invest their own money in a project, known as ‘having skin in the game.’ This investment, called common equity, comes from those managing the property and their investment partners. Common equity is the riskiest part of the capital stack but can also be the most profitable.
Common equity investors get paid last after all other mortgage debt investors and creditors. They receive payments from the property’s cash flow only after everyone else has been paid. These payments are not guaranteed but are usually given as a preferred return on their investment. If the property does well, common equity investors can earn high returns without a limit.
How Returns Differ Within the Capital Stack
In most investments, more risk can mean higher rewards. For example, common equity at the bottom of the capital stack is the riskiest but can also bring the highest returns. On the other hand, senior mortgage lenders at the top of the stack face little risk but won’t gain extra rewards if the investment does well.
However, too much risk can make an investment a problem. Investors higher up in the capital stack risk losing money if cash flow issues arise and face challenges when selling the investment. It’s important to balance risk and reward to ensure the potential returns are worth it.
Imagine you buy a retail property for $5 million using $3.5 million in senior debt and $1 million in preferred equity. Later, you sell the property for $4.3 million after property values drop.
The lender gets paid first. So, from the $4.3 million, they take what you owe on the loan. The remaining money goes to the preferred equity holders next. If there’s not enough to cover what is due to them, they take whatever is left, which might leave you with nothing.
Property values usually go up in normal market conditions. But it’s important to understand how the capital stack affects your total return on investment, especially when the market is down. This helps you see where you stand in the order of payments and the risks involved.
What impact does the capital stack have on borrowers?
The capital stack affects borrowers by influencing their cost of capital, risk, and control over the project. Senior debt has the lowest interest rates (4-5%), while mezzanine debt and preferred equity have higher rates (8-12% and 12-15%). Common equity, the riskiest, can demand returns over 20%. This mix of financing sources impacts the borrower’s overall costs and potential returns.
The capital stack allocates risk among different types of investors. Senior debt holders, who get paid first, face the least risk. Equity investors, paid last, risk losing their entire investment if the project fails. For instance, in a $10 million property foreclosure, senior debt holders recover their investment before mezzanine or equity investors.
To get a commercial real estate loan, you must also meet financial covenants tied to debt, such as a debt service coverage ratio (DSCR) of 1.25 or higher. Failing these can lead to penalties or defaults. The capital stack structure also determines how much equity the borrower must invest and their leverage. Higher leverage can boost returns but increases risk during downturns. Understanding these factors helps borrowers manage their financing to balance risk and return.
How the capital stack influences an investor’s Decision Making
The safest options for investors who want to avoid high risk are low loan-to-value, first mortgages on quality real estate. Also, secured corporate bonds from strong companies are also considered safe investments. These investments have low risk and returns, with inflation being the main concern due to their fixed low rates over long periods. They also don’t usually offer tax benefits for income or capital gains.
Investors who want capital growth or protection against inflation and can handle more risk might choose real estate equity and stocks. These investments are more affected by value changes, being first to lose and last to recover in a liquidation. However, they also have the most profit potential and can offer tax benefits, making them appealing despite the higher risk.
Investment structures within the middle of the capital stack often feature varying levels of return, with higher returns corresponding to increased risk. Typically, only equity investments can take advantage of specific tax benefits. In contrast, debt investments are subject to ordinary income taxes and generally lack mechanisms for regular tax deferral.
CapitalMax’s Role in the Capital Stack Structure
CapitalMax is popular among investors for its expertise in structuring and optimizing the capital stack for commercial real estate investments. As a preferred investment advisory firm with many positive reviews, CapitalMax provides customized financing solutions across all layers.
This ensures a balanced approach to managing risk and maximizing returns. By guiding clients through the complexities of real estate financing, CapitalMax effectively positions each project for success.