How Each Layer Of The Capital Stack Works
09 . 14 . 2019 NEWS
Commercial real estate investors often use different layers of the capital stack to grow and diversify the risk in their portfolios. By participating in both debt and equity investment layers within the stack, investors are able to mitigate risk and generate potentially higher overall returns.1
In this article we’ll examine how the capital stack works, and the pros and cons of equity and debt investment within the capital stack.
What is a capital stack?
One way to think about a capital stack in commercial real estate investing is to compare it to a layer cake. Each ‘stack’ is a different layer of debt or equity that is combined to fund the purchase, improvement, or repositioning of a real estate project.
The capital stack is arguably one of the most important tools investors use to analyze and understand the direct and indirect risks of investing capital into a project.
When everything goes right, investors are paid back based on their position in the stack. Of course, there is potential downside to any investment, and commercial real estate is no exception.
So, the capital stack is also used by investors to identify:
- Where they stand in the order of cash flow
- How their position within the capital stack affects the risk of repayment (return of capital)
- When the anticipated return (return on capital) is worth the risk of placing capital in a project
Breaking down the layers of a capital stack
In theory, a capital stack can contain any number of layers. But in the same way that a cake can only be so tall before it falls over, only so much capital can be stacked into a project.
In practice, there are four common types of capital used in a capital stack:
- Common equity
- Preferred equity
- Mezzanine debt
- Senior debt
Understanding the capital stack layers
There are several points investors should keep in mind when analyzing a capital stack and their position within the four layers of the stack:
- Each layer of capital has priority over the sources above it. In the above example, senior debt has repayment priority over mezzanine debt, preferred equity, and common equity.
- Each layer of capital is subordinate to the layers below it. For example, preferred equity is subordinate to mezzanine and senior debt, but has priority over common equity.
- As a rule of thumb, only the debt layers are able to record liens against the real property. When a property is sold or refinanced, the debt positions are paid first. Then, the other layers of the stack are paid by moving upward.
- Conversely, losses are incurred from the top down, with equity positions being the first to lose money if there are insufficient funds to repay all of the capital invested. This means two things: 1) The higher the position in the capital stack, the more risk there is, and 2) The higher the position in the capital stack the greater the potential rewards should be, as an offset to the increased risk.
Equity vs. debt in the capital stack
There are two types of capital in any capital stack – equity and debt.
Equity represents a direct ownership interest in an asset, while debt is capital given to the equity ownership in the form of a loan. Debt is collateralized by the real property and sometimes by the assets of the equity owner itself, depending on whether the loan is non-recourse or recourse.
Equity and debt can also be divided into subcategories, each with a different level of risk and reward.
Types of debt
- Senior debt: first layer of capital to be repaid if an investment goes bad, is refinanced, or the property is sold. Senior debt carries a low risk level in exchange for lower return expectations.
- Mezzanine debt: used to fill any funding gap between senior debt and common equity. Mezzanine debt is second in line to be repaid, and is usually not secured by the real property, only by an interest in the equity owner or borrowing entity. Mezzanine debt carries a medium to high risk level, with return expectations usually double those of senior debt holders.
Types of equity
- Preferred equity: third in line to be repaid and fills the funding gap between senior debt and common equity. Because of this, preferred equity is oftentimes thought of as a hybrid between mezzanine debt and common equity. While preferred equity isn’t secured by the real property or ownership entity, oftentimes preferred equity holders have the right to force the sale of a property if need be. Preferred equity investment has a medium to high level of risk, a steady stream of income in the form of dividends or distributions, and a kicker or bonus paid if profits meet or exceed a previously agreed to level.
- Common equity: last to get paid, but potentially the most profitable part of the capital stack. Lenders require borrowers or general partners to have “skin in the game” by investing their own capital in a project. Common equity investments are not secured and carry the highest level of risk in exchange for potentially unlimited upside returns.
Types of investment entities
In addition to their position in the capital stack, commercial real estate investors can also balance their risk and reward risk through the entity structure used.2
- General partner (GP) is the individual or entity actively involved in the day-to-day operations of the property but has increased liability.
- Limited partner (LP) provides limited investor liability, requires a general partner to oversee the project and to accept the liabilities that the LP does not incur.
- Joint venture partnership (JV) is a group of partners working together, each of whom brings different things to the table. Most JVs are comprised of an operating member or GP with proven experience in acquiring, developing, and managing real estate projects, and capital investors who contribute their money but don’t have the time or desire to be involved with the daily oversight.
Factors affecting risk and upside
Although common equity is often considered the part of the capital stack with the high risk and highest upside potential, not all equity investment is created equal. For example, a passive investor could negotiate an agreement with a healthy preferred return to help reduce downside risk.
Other factors of equity investment in the capital stack that can help to minimize risk and maximize reward include:
Conservatively forecasting the exit or going-out cap rate
Investors normally assume the going-out cap rate will be higher than the going-in capitalization rate due to building age and lower corresponding rent growth. However, the longer a property is held, the higher the exit cap rate may be (all other factors being equal).
Balancing the downside risk and upside potential of investing in key vs. secondary markets
Primary markets such as New York, Chicago, and Los Angeles generally offer less risk but also a lower reward due to robust demand from both tenants and investors. On the other hand, secondary markets like Fort Lauderdale, Austin, and Sacramento my present more upside potential but also a higher level of risk due to less diversified economies and comparatively lower demand from investors.
Investment strategy and the corresponding level of risk and reward
Whether the project is core, value-add, or opportunistic, and the property class being invested in (Class A, B, or C) influences the total amount of investment capital required, project complexity, cash flows, and the overall risk and reward profile and ROI of a potential investment.
How the real estate cycle affects the capital stack
In a white paper from National Real Estate Advisors entitled, “Mitigating Risk From Volatility Through The Real Estate Market Cycle” the organization examined some of the challenges and opportunities that real estate cycles create for investors.3
Factors affecting how and when capital is placed throughout the capital stack include the current interest rate environment, lender activity, and economic trends. The stage of the real estate cycle also plays a major role in determining the proper use of construction loans, preferred equity, and mezzanine debt to position for potential reversals and protection against temporary market declines.
There are four general investment parameters for investing along the capital stack throughout the real estate cycle stages:
Stage #1: Early recovery
Equity investment due to declining unemployment, low construction pricing, decreasing vacancy rates, and shortage of available bank financing.
Stage #2: Stable economy
Equity/preferred equity investment and mezzanine debt as the real estate market approaches equilibrium with rising rents, more supply brought to market, and a low unemployment rate.
Stage #3: Late cycle
Preferred equity and mezzanine debt as momentum slows due to declining cap rates, rising construction costs, and weaker rent growth.
Stage #4: Recession
Equity used to acquire investment real estate at a discounted price due to high vacancies, rising unemployment, and motivated sellers.
Making the most of each layer in the capital stack
Strategic use of the capital stack allows potentially profitable investment through all stages of the real estate cycle. By using a combination of common equity, preferred equity, mezzanine debt, and senior debt, investors can seize the opportunities created by changing markets and gain protection in downward market cycles.
In addition to market timing considerations, investors can use the capital stack to allocate capital based on investment goals and strategy. Investors willing to accept a higher level of risk may choose more exposure to equity. Those who are averse to risk may seek the relative safety and security of mezzanine or senior debt.
As the economic expansion approaches record length, the preference for commercial real estate investment continue to rapidly grow while cap rate spreads compress due to demand.4 The result is that good value can be increasingly difficult to find.
Investing in different layers of the capital stack allows investors to help mitigate overall portfolio risk while maintaining growth goals and the potential for long-term appreciation.