Depending on the size of the transaction, the finances of a real estate deal can be a complicated matter. In the largest deals, funds can come from a variety of sources/investors, each of whom have their own specifications, rules, and requirements.
Collectively, these sources are known as the “Capital Stack” and each component plays an important role in financing a deal and in establishing the risk profile of the transaction.
Capital Stack – Defined
The Capital Stack is the organization of capital used to finance a real estate transaction and there can be multiple components. The agreements for each component of the stack define who has the rights, and in what order, to the cash flow and profits generated by the asset throughout the investment’s holding period and upon sale.
There are 4 common components of the Capital Stack, any or all of which may be used to finance a real estate transaction:
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
Let’s go through each one in detail.
Senior debt is most commonly thought of as a traditional bank loan and it’s often the largest component of the capital stack, usually 65% – 75% of the purchase price.1 It’s called “senior” debt because the holder (lender) is first in line to receive debt service payments.
Senior debt is considered the least risky component of the capital stack and, as a result, typically provides the lowest return to the holder. In exchange for accepting a lower interest rate, the senior debt holder is entitled to a first position lien on the property, which gives them the ability (and right) to initiate the foreclosure/liquidation process in the event of a default. Once the property is sold, they’re also first in line to be repaid.
On occasion, there’s a gap between a property’s maximum supportable loan amount and purchase price that isn’t covered by the equity raise. In these instances, the borrower/investor may seek mezzanine debt to plug the hole and get the deal closed.
Mezzanine debt is a loan secured by a pledge of ownership interest in the purchasing entity, not the property itself. By definition, “mezzanine” means “middle” so mezzanine debt holders are second in line for debt service payments and typically enjoy a slightly higher return than senior debt holders to compensate for their elevated level of risk.
Mezzanine Debt holders don’t have a claim on the underlying property so their ability to initiate the foreclosure process is limited and can often only be done in agreement with the senior debt holders. Upon sale and/or liquidation, they’re second in line to be repaid — if there’s enough money left over to pay them.
1 Actual percentage may vary according to lender Credit Policy.
Preferred Equity isn’t a loan, it’s an investment in the entity that owns/operates the real estate asset. In terms of Capital Stack position, Preferred Equity holders sit below debt (senior and mezzanine) holders, but above Common Equity holders. As a result, they require higher returns than debt holders and profit participation upon sale (if available).
However, in the event of a foreclosure and the resulting liquidation, Preferred Equity holders are third in line to be repaid and may only receive a fraction of their initial investment back, if anything.
The last component of the Capital Stack is the Common Equity holders, who also have an equity interest in the ownership entity, but with a lower priority than Preferred Equity holders. From a risk/return standpoint, Common Equity holders make a distinct tradeoff — they’re last in line to be repaid in a liquidation scenario, but they also benefit the most from a profitable sale.
Capital Stack – A Bankruptcy Example
When a property performs as expected and each member of the capital stack is receiving their respective payments, everyone’s happy. However, if the property performs poorly and falls into bankruptcy/foreclosure, the details regarding the rights and priority of each Capital Stack position are critical. To illustrate this concept, consider the following example.
An investor identifies a property, does their research, and makes an offer to purchase it for $3M. The property supports a loan amount of $1.8M (60% Senior Debt), which means the investor needs to find $1.2M to close the deal. After calling other investors, they secure $800k in Common Equity and $200k in Preferred Equity. To round out the Capital Stack, they obtain the remaining $200k needed in the form of Mezzanine Debt. See the diagram to the left for a depiction of the resulting Capital Stack.
Next, let’s assume that, after two years of underperformance, the senior debt holder forecloses on the property and liquidates it at a sale price of $2M, which results in a $1M loss. The priority order of the capital stack determines who absorbs it.
With $2MM in liquidation proceeds, the Senior Debt holder is repaid first, and in full, leaving $200M remaining.
Because the Mezzanine Debt holder is in second position and they’re owed $200M, they’ll get the remaining money.
Preferred and Common Equity holders will be left with nothing and their investment will be lost.2
2 Scenario is for illustrative purposes only. Depending on the state in which bankruptcy was filed, accrued interest may affect repayment and actual repayment terms may vary.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
We carefully consider the composition of the Capital Stack for every deal that we invest in and make sure that the interest of our investors is protected. Whether you’re just getting started as an investor or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
Glossary of Key Terms
Capital Stack: The organization of capital used to finance a real estate transaction. It defines who has the rights, and in what order, to the cash flow and profits generated by the property throughout the holding period and upon sale.
Holding Period: An investor’s holding period is defined as the amount of time for which they plan to hold an investment. It’s usually expressed in either months or years.
Senior Debt: Senior debt is most commonly associated with a bank loan and it’s the base or foundation of the capital stack. It usually makes up the largest portion of the financing, often 65% – 75% of the purchase price1 and the holder is first in line to receive periodic debt service payments.
Mezzanine Debt: Mezzanine debt is a loan, not secured by the property, but by a pledge of the ownership interest (common equity shareholder). Mezzanine debt holders are second in line for periodic debt service payments and typically enjoy a slightly higher return than senior debt holders to compensate for the elevated risk.
Preferred Equity: Preferred Equity isn’t a loan, but an investment in the ownership entity of the property. Preferred equity holders sit below debt holders, but above Common Equity holders. As such, they require higher returns and participate in the profits upon sale.
Common Equity: Common Equity represents an interest in the ownership entity, but they sit behind the preferred equity holders. As such, they require the highest returns of anyone in the Capital Stack and typically stand to benefit the most from a profitable project.
Interest Rate: The percentage of a loan’s principal balance charged by the lender for the use of it’s money.
Lien: A right to keep possession of property belonging to another person until a debt owed by that person is paid.
Foreclosure: The action of taking possession of a mortgaged property when the mortgagor fails to keep up their loan payments.
Default: Failure to fulfill an obligation, especially to repay a loan. The conditions of a default are defined in the Loan Agreement.