One of the first things you have to understand when you decide to start investing in commercial real estate is where the money that you invest falls in what is called the capital stack. The capital stack of a deal outlines how a deal is being financed. Each layer of the capital stack comes with a different risk/reward profile, and where you are in the capital stack will determine when you will get paid and how relative to the other investors in the deal.
With any investment, it’s important to know your goals for the investment as well as how much risk you’re willing to take on. This article will explain the different positions in the capital stack as well as different things to consider when determining where in the capital stack you’d like to fall.
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We have a guide on syndications that covers all the basics: how to invest, what you can expect, terminology to know, and concepts involved in vetting deals.
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Introduction: What Is the Capital Stack?
As stated above, the capital stack outlines the financing sources of a commercial real estate deal. Most real estate deals are financed by both debt and equity sources. This is often subdivided into senior debt, mezzanine debt, preferred equity, and common equity positions. These can be further subdivided into as many layers as the person sponsoring the deal would like to accommodate different terms offered to different groups of investors, further complicating things, but the general concept of the capital stack remains as follows:
The cashflows and profits (assuming they exist!) from a real estate deal are paid out to the capital stack from bottom to top. Generally the people at the top of the capital stack have higher returns on each dollar invested.
So, those at the bottom of the capital stack are in less risky positions and are paid first, but have lower potential rewards. The higher you go in the capital stack, the riskier your position, but the more potential for returns.
Debt is on the bottom of the capital stack and equity is on the top of the capital stack. In many syndications, as an LP investor you are at the top of the capital stack in the common equity position, which allows you the best returns if a project does well, but also the most risk. Sponsor co-investments are also at the top of the capital stack.
For avoidance of doubt, if a project goes wrong, whatever remaining assets and monies there are will be paid first to the bottom of the capital stack (the debt) and then flow upwards until the money runs out. So if you are at the top of the capital stack, it may be that the people at the bottom lose nothing, but you lose everything.
What Comprises the Debt Portion of the Capital Stack?
As we said above, debt is the least risky position to be in. This is because the debt side typically receives interest payments throughout the life of the deal, and when the project is completed, sold, or refinanced, they are the ones who are paid out first. This is very similar to the way the bank works on the mortgage of your home, where if you aren’t able to make your payments, the bank can foreclose on your property. Those investing on the debt side of the deal are essentially acting as the lender, who will get the same return regardless of how well the deal does. Just like you lock in on your mortgage rate, the project owes these lenders the same percentage back on the amount borrowed, and any additional profit is distributed on the equity side.
We mentioned senior debt and mezzanine debt above. Senior debt is usually the majority of the financing of a project, and is essentially a mortgage. This is generally provided by a bank although there are some opportunities to invest in this portion as well. This means that it receives interest payments throughout the project and that it is a secured loan backed by the property, so the property can’t be sold until the senior debt is paid. If you think about the mortgage rates on your house though, you know that the percentage returns you pay your bank are generally lower than what you see being proposed in real estate deals.
Conventional investment properties require a 25% down payment, which in these deals is usually made up of the equity raised by common investors and the sponsor co-invest. That usually means that 75% of a property is usually financed by debt. These days, banks are becoming more and more cautious about the risk associated with holding 75% of the financing, and are offering less of the financing. In this case, if a sponsor of a real estate deal finds that they don’t want to give up more equity in a deal or that they can’t raise enough equity, they may turn to additional sources of debt financing that can loan them money in a way that is less expensive that paying out LP investors in the equity portion of a deal. This is where mezzanine debt comes into play.
Mezzanine debt sits right on top of the senior debt in the capital stack, so they get paid after the senior debt, and as such, get paid higher returns than the senior debt for the additional risk. They can also get interest payments. The entity providing the senior debt usually gets to weigh in on who can be part of the mezzanine debt.
If you are a real estate investor that wants conservative returns with less risk and more predictable regular payments, this may be the optimal position for you.
Are There Any Downsides To Investing in the Debt Portion of the Capital Stack?
As we said, one major downside is that you don’t get to share in the upsides of profits if a deal does really well. As a debt investor, you are not an owner in the project, so you are just paid back what was promised to you.
One thing to keep in mind in today’s inflationary and mortgage rate environment is that if you are on the debt side of a deal for a long period of time, the value of your returns could be diminished if there is significant inflation during the hold period. For example, three years ago, a guaranteed return of 6% may have sounded pretty good, but these days (December 2023) when short-term investments are yielding 5%+, you may not think the 6% is worth the additional risk involved with real estate over something like treasury bonds or a high yield savings account.
The other issue with not being an owner is that you don’t get some of the tax benefits we often talk about as one of the reasons to invest in real estate. Unless you are able to invest on the debt side through a tax advantaged structure such as a REIT, you will pay ordinary income tax on all interest payments/dividends you generate from the investment.
What Comprises the Equity Portion of the Capital Stack?
The equity portion of the capital stack can become quite complicated depending on the terms negotiated with the deal sponsor and the respective amounts that investors are putting in, but for simplicity, we will discuss it as two groups, preferred equity and common equity.
In either position, you are an actual owner in the property, and you are paid after the debt portion of the capital stack, meaning that you assume a lot more risk than those financing the debt. This is not always a bad thing for those who are looking to make larger returns, as in exchange for the increased risk, you have a shot at higher upside.
In many syndication deals, there is a preferred return that is given to the shareholders on the equity side. This is the amount that is paid to you ideally during the life of a deal, but ultimately before the sponsor takes a cut of the profits. Of note, it is not promised to you that you will get the preferred return during the hold period, but you will accumulate the value of that preferred return and it will be distributed to you once the cash is available to distribute to you. If you are in the preferred equity position, you get a higher preferred return than those in the common equity position.
Preferred equity sits between the debt and the common equity. The interesting thing about this position is that you function almost like the debt portion of the capital stack in that you have a fixed return on your investment that is paid before the common equity, but you get a higher return that the debt position because you are essentially providing an unsecured loan, which is much more risky than having a lien position against an investment. You generally will get your preferred returns throughout the investment period assuming that a deal is doing well, but you are not guaranteed to get them during that time and may have to wait until the project is sold to free up the cash to pay you your preferred return. You do not typically share in the upside of the project in this position; it’s just that you get a better return than you would have on the debt side.
Then comes common equity. When you hear people on our physician communities saying that they made a huge return on their real estate investment, it’s because they’re on the common equity side and the project did really well. This is also where the deal sponsors sit in the equity stack most times. While this position is the riskiest because you get paid last, if a property doubles or triples in value, it is those in the common equity position that benefit.
As an equity owner, you do get to take advantage of the tax benefits of real estate, including depreciation and possible 1031 exchange opportunities.
If you can afford to take the risk of being paid last (and therefore the most likely to lose money in a real estate deal), but want to have a chance at larger returns, the common equity position likely makes the most sense. If you can take some risk but don’t want to be paid last, you may prefer the preferred equity position where you have a fixed return that’s on the higher side, but not share in the profits if the deal does really well.
Do I Have To Choose either Debt or Equity?
It really just depends on the deal. Some sponsors have the ability to invest in different portions of the capital stack. A common situation we have seen is where you can split some of your investment in the common equity position and some in the preferred equity position to hedge your bets a little bit, where you know a certain percentage of your money will get paid out prior to the common equity position. Talk to your deal sponsor about what options are available to you and pick what fits with your financial plan and goals for real estate investing.
What Happens When a Deal Goes Bankrupt?
While some of this is dependent on local laws and bankruptcy proceedings, usually there is a pecking order of payout. We’ve already talked about the order in which the money goes from bottom to the top of the capital stack, but before even the debt gets paid out, there may be other things that need to get paid first, such as taxes and outstanding employee wages.
What Are Some Things I Should Think About When Deciding What Position To Take?
As discussed above, the biggest factor is how much of a risk you are willing to take. But how do you know how risky that top position in the capital stack is?
We talk about this a lot on our real estate education series, but it is essential that you learn to underwrite and evaluate deals yourself instead of taking somebody’s word for it. You want to actually assess how good a deal is and what the chances of it performing the way that the deal sponsor says it will be are. We talk about how to do this in our primer on syndications. You want to learn how to use a cash on cash calculator to see how a real estate investment will cashflow, and know that you believe the cashflow numbers being generated by the property will be enough to pay back the debt and leave some money for you.
Conclusion
All investments have risks associated with them. As an investor, your job is to decide what level of risk you’re willing to take on, and see if the returns provided at that level of risk make sense for your financial objectives. Understanding the capital stack of a deal will allow you to understand how risky your investment is in the chance that a real estate deal does not perform as projected.