What is the capital stack?

Understanding the Capital Stack in Commercial Real Estate

When investing in commercial real estate, it's important to understand the capital stack. The capital stack refers to the structure of all the financial sources used to fund a real estate project. Each layer of the stack comes with its own risk and return profile.

Investors should familiarize themselves with the different layers to make informed decisions. The capital stack typically includes senior debt, mezzanine debt, preferred equity, and common equity. Understanding these layers can help investors assess their risk tolerance and potential returns.

secure layer of the capital stack. Lenders who provide senior debt have the first claim on the property's cash flow and assets. This means they get paid first in case of a default. Because of this security, senior debt usually offers lower interest rates.

Borrowers often use this layer to fund a significant portion of the project. However, the amount of senior debt is usually limited by the loan-to-value (LTV) ratio. Lenders typically require an LTV ratio of 60-80%.

Mezzanine Debt

Mezzanine debt sits below senior debt in the capital stack. It acts as a bridge between senior debt and equity. This layer is riskier than senior debt but offers higher returns. Mezzanine lenders have a secondary claim on the property, meaning they get paid after senior debt holders.

can convert their debt into equity. This gives them some control over the property. Borrowers use mezzanine debt to fill the gap between senior debt and equity, often allowing them to fund up to 90% of the project.

Preferred Equity

Preferred equity is another layer in the capital stack. It offers investors a fixed return, similar to debt, but with the potential for upside. Preferred equity holders have a higher claim on the property's cash flow than common equity holders but a lower claim than debt holders.

This layer provides a balance of risk and reward. Investors in preferred equity benefit from both the stability of fixed returns and the potential for higher returns if the property performs well.

Common Equity

Common equity is the riskiest layer of the capital stack. It represents ownership in the property and comes with the highest potential returns. Common equity holders get paid last, after all other layers. This means they bear the most risk but also stand to gain the most if the project succeeds.

Conclusion

Understanding the capital stack is crucial for anyone investing in commercial real estate. Each layer has its own risk and return profile, and knowing these can help investors make better decisions. By assessing their risk tolerance and investment goals, investors can choose the right mix of debt and equity for their portfolio.

Whether you're a seasoned investor or new to commercial real estate, taking the time to understand the capital stack can pay off in the long run. It allows you to navigate the complexities of real estate financing and make informed investment choices.