In a commercial real estate deal, the Capital Stack is simply the combination of every type of funding which goes into the purchase and improvement of a particular project.
A capital stack involves multiple layers. Each layer has its own characteristics and return to investors.
Debt & Equity
The second is Debt. This is one or more loans given to the equity ownership. Debt is almost always collateralized (secured) by the asset itself or other assets of the equity owner.
The capital stack is a useful approach to understanding how complex transactions are put together. It outlines the relationship between the equity and the debt. In almost every case, the bottom of the stack represents the lowest risk, while the topmost layer represents the highest risk. The lowest layer has the highest seniority, while the topmost layer has the lowest.
Seniority becomes important in the event of bankruptcy or restructuring. High seniority means high probability of coming out whole on the deal. Low seniority could mean losing one’s capital investment.
Rates of return are tied to seniority. High seniority, in the form of first position debt, demands the lowest returns (interests rates), while low seniority, as in investor capital, demands the highest returns. In a typical LLC structure, these returns can be classified as “priority” or “preferred” returns to investors.
Because equity investors are owners of the asset there is no fixed term for the investment; full payout only occurs when the asset is sold or an individual investor sells his/her ownership interest.
In almost all commercial real estate transactions, a sponsor (often a manager or developer) contributes a small portion of the equity and is responsible for the management and performance of the actual investment.
The sponsor usually contributes between 5% and 20% of the equity. The remaining capital is raised from investors who take a senior position within the equity itself, frequently receiving a preferred return and first payback rights.
The Middle Layers
More complex real estate deals involve additional layers of capital added to the stack that often act as a hybrid between equity and debt. This category is often referred to as mezzanine debt or preferred equity. As a hybrid structure, this type of investment is senior to traditional equity investment but subordinate to the debt. Often the return structure is also a hybrid between true equity or debt, where mezzanine/preferred equity investors receive a fixed annual payback over a specific investment term but potentially can participate in the upside or continued success of the investment.
The Capital Stack helps investors understand real estate deals by visualizing the placement of risk and return for each layer of capital. With every real estate deal being unique, and each Capital Stack comprised of its own unique layers, it is important for investors to fully understand the potential risks at each point in the stack and also have a clear outline of exactly what returns they are entitled to.