Steve Carney 
Capital stack is an important concept to understand when investing in real estate. A real estate project is financed using various forms of financing. The following article explains how the capital stack affects real estate investments and what you should know about it.
What is a Capital Stack?
The term capital stack refers to the various financing layers used to fund a real estate project. There are multiple ways to structure these layers, depending on the type of project and the financing requirements. A typical capital stack consists of the following layers:
- Senior Debt: Typically, this consists of a mortgage loan secured by the property as the first layer of the capital stack. A bank or a financial institution is typically the lender for this layer, which has the highest priority for repayment.
- Mezzanine Debt: Private equity firms or hedge funds typically provide this layer of debt as a subordinate to senior debt. The interest rate on mezzanine debt is generally higher, and it can be converted into equity if the borrower defaults on the loan.
- Preferred Equity: Senior and mezzanine debt is subordinated to this layer, and the investor receives a fixed return. Regarding repayment, preferred equity holders have priority over joint equity holders. However, they do not have voting rights.
- Common Equity: The layer representing company ownership is the most subordinate in the capital stack. As common shareholders, you are the last to receive a payment in the event of default, but you have voting rights and the opportunity to participate in the company’s management.
How Does Capital Stack Affect Real Estate Investment?
Understanding the capital stack is crucial for real estate investors as it helps them understand the risks and rewards associated with different types of investments. Depending on the type of investment, the capital stack can significantly impact the returns that an investor can expect.
For example, investing in a project that has a higher proportion of senior debt in the capital stack will typically provide a lower return but will be less risky. On the other hand, investing in a project with a higher proportion of mezzanine debt or equity will typically provide a higher return but will be more difficult.
In addition, understanding the capital stack can also help investors negotiate better terms and financing arrangements with lenders and equity partners.
How is the Capital Stack Structured?
The capital stack can be structured in different ways depending on the type of real estate project and the financing requirements. Generally, the capital stack is structured in a way that provides the lowest cost of capital for the borrower while at the same time providing the highest level of security and protection for the lender.
For example, in a project with a high loan-to-value ratio, the capital stack may be structured to include a higher proportion of equity and mezzanine debt. In a project with a lower loan-to-value ratio, the capital stack may be structured to have a higher proportion of senior debt.
Why is the Capital Stack Important for Lenders?
Lenders play a critical role in the capital stack, providing the financing needed to fund real estate projects. By understanding the capital stack, lenders can evaluate the risks and rewards associated with different types of investments and structure the financing to provide the best returns for their investors.
Lenders also use the capital stack to assess the borrower’s creditworthiness and the risk associated with the project. By analyzing the various layers of the capital stack, lenders can determine the borrower’s ability to repay the debt and assess their level of protection and security in the event of a default.
Why is the Capital Stack Important for Investors?
Investors play a critical role in the capital stack, providing the equity and mezzanine debt needed to fund real estate projects. By understanding the capital stack, investors can evaluate the risks and rewards associated with different types of investments and structure their assets to provide the best returns for their capital.
Investors also use the capital stack to assess their protection and security level in the event of a default. By analyzing the various layers of the capital stack, investors can determine their priority in the repayment waterfall and assess the risk associated with their investment.
Conclusion
In conclusion, understanding the capital stack is crucial for real estate investors as it helps them understand the risks and rewards associated with different types of investments. By knowing the different layers of the capital stack, investors can make informed decisions about their assets and negotiate better terms with lenders and equity partners. We hope this article has given you a comprehensive understanding of the capital stack and how it affects real estate investment.
