How the Capital Stack Works in Commercial Real Estate
Intro – What Is the Capital Stack?
The “capital stack” refers to the full set of financing instruments used to fund a given real estate investment. Every homeowner understands the difference between their mortgage and the equity they have in their home, but commercial real estate finance can be much more complex, involving numerous parties and a variety of structures. A variety of finance instruments may be in play for any given commercial real estate transaction, some of which have grown in prominence over the past several decades. Even experienced investors may benefit from a review of the capital stack, and the material differences between equity, preferred equity, mezzanine debt, and senior debt.
Much like a single-family home purchase, a real estate investment firm (a “sponsor”) will often seek a loan from a large bank at an attractive interest rate, subject to the bank’s underwriting and leverage standards. The sponsor will also contribute some amount of their own capital in the form of equity. In order to reclaim capital for other purposes, or to meet the capital requirements of the project, the sponsor will seek additional financing in the form of debt and/or equity to close the gap between total forecasted project cost and the financing already on-hand from a bank loan and/or their own capital. This overall financing structure (the capital stack) can reflect an infinite number of variations to suit the requirements of the sponsor, the project, and additional investors, and may be complex – with multiple tranches of mezzanine debt or senior debt that are later syndicated out into multiple notes. The equity component of the capital stack may be arranged in complex waterfall payment structures and return hurdles (which we’ll discuss in greater depth later in this series).
For now, let’s focus on the four components of the capital stack you’re most likely to encounter when investing in real estate through an online investment or crowdfunding platform, going from the least to most risky: senior debt, mezzanine debt, preferred equity, and common equity.
…is secured by a mortgage or deed of trust on the property itself; if the borrower fails to pay and defaults on the loan, the lender is entitled to take title to the property. This greatly reduces risk on the principal invested because, at worst, the lender owns the property and will look to maximize value by selling the property or selling the non-performing loan. The “cost” of this lower level of risk is a lower yield on the money invested. Senior debt investors will be entitled to a lower target return than all higher positions in the capital stack, over whom the senior debt investor will have payment priority. To properly understand the risk involved, look at the loan-to-value (“LTV”) ratio of the loan – if the loan has a 60% LTV there is a lot more margin for error than an 85% LTV loan. It’s a simple analysis: in the worst case scenario, as the lender, you’d much rather end up owning the property at 60% of its value than 85%.
As with any commercial real estate investment, senior debt investors will want to take a close look at the sponsor’s (i.e. the borrower’s) ability to service their debt obligation. The debt service coverage ratio and total leverage should come into focus. Real estate investing platforms may offer senior debt investments as a direct line of capital to the borrower, such that individual investors are effectively lending to the sponsor. The platform may also “syndicate” a preexisting loan from a lender – so that individuals are passively investing alongside a private CRE lender. In either case, individual investors should consider the experience and track record of both the borrower (sponsor) and the lender, be that the platform itself or a separate private lender.
…sits below the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the fixed coupon of the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called an intercreditor agreement, where they spell out how their rights interact (i.e., what happens if a developer stops paying both of them). Mezzanine debt typically has a higher rate of return than senior debt but lower than equity.
In cases that the capital stack includes both mezzanine debt and preferred equity, mezzanine debt typically carries payment priority over preferred equity and consequently offers a lower rate.
For more on mezzanine debt, how it is used, and the particulars of investing at this point in the capital stack, please refer to this article.
…is perhaps the hardest portion of the capital stack to speak about generally because, for better and worse, it’s very flexible. Preferred equity holders have a preferred right to payments over regular (common) equity holders. “Pref” equity positions range from “hard” preferred equity, which function similarly to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or remove the borrower (the sponsor or developer) if they fail to make payments, soft preferred equity holders typically have more limited rights. As you’d imagine, the rate of return for hard preferred equity is similar (or slightly better) than mezzanine debt, while soft preferred equity returns can be substantially better.
Preferred equity investors are entitled to returns that are paid prior to common equity holders receiving distributions (this is the “preferred” in preferred equity). Because of this as well as recourse that preferred equity holders may have in the event of a borrower default, preferred equity is considered less risky than common equity, and hence preferred equity investor’s entitled to upside will be capped.
Preferred equity and mezzanine debt fulfill similar functions in the capital stack: forms of “bridge financing” – methods of financing short-term capital needs to fill a gap between the debt and equity components of the overall project’s capitalization. Both entail some recourse provisions for the holder of the position.
For more on the benefits of preferred equity real estate investing, and how it is used in the capital stack, please review this article.
Common Equity…The Top of the Capital Stack
…is the riskiest and most profitable portion of the real estate capital stack. Typically the GP investor (the developer or sponsor) will be required – by the lender and/or by other equity investors – to invest their own money as some portion of the equity to have skin in the game. Equity investments carry the greatest risk, because investment agreements entitle every other tranche of capital to be repaid before common equity holders. However, if the property performs well, equity investors usually have no cap on their potential returns. In real estate, equity is typically structured so that all investors earn a preferred return until they hit a certain annual return hurdle (i.e., 8%). After that, the developer or sponsor will earn a disproportionate share of the profits (i.e., 40% of all the remaining profit), while investors receive the rest of what’s left pro rata. For more on preferred return in real estate, please refer to this article.
Though common equity is generally the highest-risk, highest-upside portion of the capital stack, not all common equity investments are created equal with respect to risk/return profile. A healthy preferred return written into an investment agreement can mitigate some downside risk for passive investors (we typically strive to negotiate attractive preferred returns on behalf of EquityMultiple investors).
Other qualitative and quantitative attributes of an equity investment can impact the attendant risk and potential upside. Some of these factors include:
- Capitalization Rates: how conservatively the exit (or “going out”) cap rate is modeled. For more, please review this article.
- Market: Generally, gateway markets like New York City or San Francisco will offer more downside protection (less risk) but, accordingly, less upside potential. This is because dense, affluent knowledge centers such as these enjoy robust and diverse rental demand but are hence home to some of the most competitive real estate markets in the world, dampening return potential. It’s no coincidence that markets like New York City become particularly appealing for global investors in times of economic volatility. Conversely, lesser-known secondary and tertiary markets may offer more robust demand growth opportunities, and upside for commercial real estate investment, but greater risk due to less established, less diverse local economies.
- Business Plan: Equity investments can offer an array of risk/return profiles based on the underlying strategy. The amount of capital expenditure needed, the complexity of the project, and the in-place rent roll and cash flow all impact the risk and potential return of an investment. For more on this topic, please review this article.
Such considerations matter for investments throughout the capital stack. However, such attributes of an investment can magnify risk and return potential for a common equity investment to a greater extent, as passive investors have fewer protections but can enjoy uncapped upside.
Conclusion – The Capital Stack and Your Portfolio
Understanding the different investment structures across the capital stack is critical to making real estate part of your portfolio. Much like investing in stocks and bonds, how you allocate between equity and debt real estate investments should depend on your investment goals and strategy, including your risk tolerance. For risk-tolerant investors, heavier exposure to real estate equity may be more appealing. Risk-averse investors may find the relative security and short terms of senior debt or mezzanine debt more appealing. While studies repeatedly show that “timing the market” is next to impossible, even for experienced investors, timing considerations can also help guide portfolio strategy.
As of Q3, 2020, with the economy facing myriad challenges as a result of COVID-19, diversification across investment structures and target hold periods is all the more critical. Strain on credit markets may generate opportunity for private lenders, and hence senior and mezzanine debt opportunities, while demand dislocations may create a new universe of value-add common equity opportunities.
After many years of a bull market, where good value equity investments became increasingly scarce, this massive disruption of the global economy will create a wide array of new opportunities across markets and across the capital stack as new debt and equity capital needs emerge. For most investors, a diversified approach makes sense both for the real estate portion of their portfolio and the portfolio as a whole. Investors can potentially reduce overall risk exposure while maintaining long-term appreciation and upside by spreading their real estate investments across the capital stack.
Up Next >>> Commercial Real Estate Due Diligence
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