SS118: What is a Capital Stack in Real Estate

SS118 What is a Capital Stack in Real Estate

Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing What is a Capital Stack in Real Estate.

Understanding the capital stack is instrumental when evaluating different real estate investments. In this episode, Charles discusses the real estate capital stack; what it is and why it is important when investing in real estate.

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Talking Points:

  • Most commercial real estate properties are expensive and the majority of real estate investors do not have the capital to purchase it outright with cash. The capital stack is a key component for investors when weighing the potential risks and returns associated with any real estate deal. It identifies who gets paid, in what order, and how much risk they will carry during the hold period of the investment.
  • What is a Capital Stack?
    • The capital stack refers to the various layers of funding (equity and debt) that are required to finance a real estate investment. The capital stack is the collection of capital used to purchase the property; it is the organization of debt and equity in a particular deal while also prioritizing different capital types by seniority. The capital stack, within the realm of real estate, refers to three concepts and rights;
      • Tiers of financing sources; debt and equity
      • Order in which investors are paid back; through income and profit distributions during the hold period.
      • Repayment rights; in the event of a default
    • These are four layers to a real estate capital stack. Not every deal will utilize all 4 layers. I have done commercial real estate deals using; 1 layer, 2 layers, and 3 layers. The larger the deal; typically, the more layers are required. I will start from the bottom up; the bottom is the safest position in the capital stack.
      • #1 is the senior debt also known as the 1st Senior debt is the foundation of the capital stack. This position is secured by the physical asset and is the safest layer in the capital stack. If a property performs and generates cash flow; senior debt holders are paid first; before any other capital contributors are paid. If the senior debt is not paid and the borrower defaults; senior debt holders have the highest claim on the underlying asset. Since it is the most secure; debt investors receive the lowest return.
      • #2 is mezzanine debt. Mezzanine is also referred to as “subordinate debt” or” junior debt” or simply “mezz.” “Mezza” is Italian for “middle” and it is similar to a second-position lender. Mezzanine debt is a higher risk since it is behind the senior debt in priority and for this, the interest rate is higher than senior debt. Mezzanine debt is really a hybrid of debt and equity. If the property defaults on the senior debt; the mezzanine lender will most likely take over the property. Mezzanine debt is usually not secured by a recorded interest in the property itself and it is provided by private equity investors that are comfortable with owning the property. The details of mezzanine debt vary depending on the overall risk of the real estate deal.
      • #3 is preferred equity. Preferred equity is similar to mezzanine debt where it fills the middle gap between senior debt and common equity. Whereas senior debt is paid before mezzanine debt; preferred equity is paid before common equity. Investors with preferred equity have the first right to receive a proportion of the monthly cash flow. Preferred equity holders usually receive a fixed return without any share in the upside, but this can vary from deal to deal. Preferred equity investors, similar to mezzanine lenders, are typically private equity firms. Most of the preferred equity deals we have done are structured where the preferred equity investors are paid a fixed monthly return of 9%-12%.
      • #4 is common equity. Common equity investors own a piece of the property and receive a share of the recurring cash flow. However; funds are only paid out to common equity investors after the other layers of the capital stacks have been paid. Potential returns for common equity investors are typically not capped. If the property performs well; common equity investors could realize very sizeable returns; but they are last in line to receive their share of income and profit distributions. Common equity investors have the most to lose if a property does not perform as anticipated.
    • Why is the capital stack important?

The capital stack balances risk and reward. Real estate investing involves risk and there is a specific relationship between the amount of risk that an investor takes on and the potential return that they can realize. For example; a highly leveraged asset that performs well will generate higher returns for equity investors however; this makes the equity position must riskier. Investors must be aware of where their investment lies in the capital stack in order to accurately assess their risk exposure.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is a capital stack in real estate.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
Most commercial real estate properties are expensive and the majority of real estate investors do not have the capital to purchase it outright with cash. The capital stack is a key component for investors when weighing the potential risks and returns associate with any real estate deal. It identifies who gets paid in what order, how much risk they will carry during the whole period of the investment. So what is the capital stack? The capital stack refers to the various layers of funding, equity and debt that are required to finance a real estate investment. The capital stack is the collection of capital used, the purchase, the property. It is the organization of debt and equity in a particular deal, while also prioritizing different capital types by seniority. The capital stack within the realm of real estate refers to three concepts and rights. First is the tiers of financing sources, debt and equity. Second is order in which investors are paid back through income profit distributions during the hold period. And third is repayment rights.

Charles:
In the event of a default, there are four layers to a real estate capital stack. Not every deal will utilize all four layers. I’ve done commercial real estate deals using one layer, two layers and three layers. The larger the deal, typically the more layers that are required. I will start from the bottom up, the bottom being the safest position in the capital stack. So number one is the senior debt, also known as the first mortgage. Senior debt is the foundation of the capital stack. This position is secured by the physical asset and is the safest layer in the capital stack. If a property performs and generates cash flow, senior debt holders are paid first before any other capital contributors are paid. If the senior debt is not paid and the borrower defaults, senior debt holders have the highest claim on the underlying asset. The property, since it is the most secure debt investors receive the lowest return.

Charles:
Number two is mezzanine debt. Mezzanine also required as also referred to as subordinate debt or junior debt or simply Mez. Meza is Italian for middle and is similar to a second position lender. Mezzanine debt is higher risk since it is behind the senior debt and priority. And for this, the interest rate is higher than senior debt. Mezzanine debt is really a hybrid of debt and equity. If the property defaults on the senior debt, the mezzanine lender will most likely take over the property. Mezzanine debt is usually not secured by a recorded interest in the property itself, and it is provided by private equity investors that are comfortable with owning the property that you know, the details of mezzanine debt vary depending on the overall risk of the deal and can vary from deal to deal. Number three is preferred equity. Now, preferred equity is similar to mezzanine debt where it fills the middle gap between senior debt and common equity, whereas senior debt is paid before mezzanine debt, preferred equity is paid before common equity.

Charles:
Investors with preferred equity have the first right to receive a proportion of the monthly cash flow. Preferred equity holders usually receive a fixed return without any share of the upside, but this can vary from deal to deal. Preferred equity investors similar to mezzanine lenders, are typically private equity firms. Most of the preferred equity deals we have done are structured where the preferred equity investors are paid a a fixed monthly rate usually of 9% to 12%. Now number four is common equity. Now this is where a lot of investors are coming in. If you’re a past investor, this is usually the layer that you’re coming in on. Common equity investors own a piece of the property and receive a share of the recurring cash flow. However, funds are only paid out to common equity investors after the other layers that the capital stacks have been paid.

Charles:
Potential returns for common equity investors are typically not capped If the property performs well, common equity investors could realize very sizable returns, but they are last in line to receive their share of income in profit distributions. Common equity investors have the most aloof if a property does not perform as anticipated. So why is the capital stack important? Well, the capital stack balances risk and reward. Real estate investing involves risk, and there is a specific relationship between the amount of risk that an investor takes on and the potential return that they can realize. For example, a highly levered leveraged asset that performs well will generate higher returns for equity investors. However, this makes the equity positions much riskier. Investors must be aware of where their investment lies in the capital stack in order to accurately assess their risk exposure. So I hope you enjoy. Please remember to rate, review, subscribe, submit comments and potential show topics at globalinvestorspodcast.com. Look forward to two episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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