Investing frequently requires substantial capital, and it’s not uncommon to secure funds from multiple sources. Capital stack refers to the various layers of funding used to purchase, develop, and operate a commercial property. If you’re doing any of these things with commercial real estate, and especially if you’re purchasing, you must understand the property’s capital stack.
What is Capital Stack in Real Estate?
Capital stack in real estate refers to the layered structure of capital invested in a real estate project. It outlines the sources and amounts of funding used to fund the project, from debt financing to equity investments. Each layer has its own risk profile and return expectations, and the capital stack shows the hierarchy of the different funding sources.
Why is Capital Stack Important in Commercial Real Estate?
A commercial property’s stack is important because it shows the order in which financial obligations are honored, and the associated risk with these obligations. Investors and lenders need to understand a property’s capital stack if they’re to accurately evaluate their loans and investments.
Components of Real Estate Capital Stack
Commercial real estate capital stacks can be much more complex than how standard single-family home purchases are financed.
The typical home purchase stack consists of the homebuyer’s equity and lender’s mortgage. A few first-time or specially qualified home buyers might have a grant or second that’s also included, and some longer-term homeowners could have a HELOC. This is about as complicated as residential lending normally gets.
In contrast, commercial real estate stacks are frequently made up of multiple investments and loans. These are usually structured according to the position of their claim on the project, and the associated risk that comes with the position. Some standard components that are typically included in a commercial real estate capital stack are:
- Senior Debt: This is the most secure layer of the capital stack, and most often is supplied by banks or other institutional lenders. Senior lenders have first priority in receiving payments in case of default, but they also receive lower interest rates because their stake is more secure.
- Senior debt is normally the primary mortgage used to purchase a commercial property. Senior debt can sometimes also include secondary mortgage programs, such as a supplemental loan for energy efficiency improvements.
- Mezzanine Debt: This layer sits below senior debt in terms of priority, but offers higher interest rates in exchange. Mezzanine lenders often also receive some form of equity participation in the project.
- Preferred Equity: Preferred equity investors may be entitled to a fixed dividend payment, assuming all debt obligations are met. Preferred dividends are paid before common equity divestments can be made, but preferred equity holders may have less upside potential.
- Common Equity: Common equity investors, often known as “sponsors,” are the most junior stakeholders in the capital stack. They bear the most risk, but also stand to gain the most if the project is successful.
Example of Commercial Capital Stack
For an example of how a commercial capital stack may be used to fund the purchase of a property, consider a building that requires $100 million in funding. The funding might require $80 million for the purchase, and another $20 million for renovations and repairs:
- Senior Debt: $64 million may be financed through a primary mortgage. This is 80% of the current $80 million valuation.
- Specialized Loan: $5 million may be financed through a specialized loan program for energy-efficient upgrades.
- Mezzanine Debt: $15 million may come from mezzanine debt-equity agreements. This is 15% of the project’s total funding.
- Preferred Equity: $10 million may come from preferred equity investors, accounting for 10% of total funding.
- Common Equity: $6 million may come from common equity investors, accounting for the final 6% of funding.
Any payments made to debt holders and investors would follow this list in order, with senior debt being serviced first and common equity being returned last. Obviously, preferred equity and common equity investors should know how many parties have financial claims ahead of theirs.
Benefits of Having Capital Stack in Commercial Real Estate
Sometimes newer commercial real estate investors are resistant to having a large capital stack, initially preferring to keep the number of stakeholders limited. Creating a diverse and well capital stack offers several key benefits, however:
- Reduced Risk: Diversifying funding sources reduces the risk that any one source faces. It also reduces how dependent the project is on any one lender or investor.
- Increased Liquidity: Specifically bringing on more investors can make exiting the investment easier, as more parties may be willing to purchase an investor’s stake.
- Financial Flexibility: Different capital stack structures can be tailored to specific projects and market conditions, allowing investors to access capital in a way that best suits their and the project’s needs.
- Maximized Returns: By leveraging debt financing, sometimes through multiple loan programs, investors can increase their potential returns. This also increases potential risk, though.
Risks Involved with Capital Stack in Commercial Real Estate
While capital stacks offer several benefits, there are also risks involved:
- Increased Complexity: The capital stack can be complex to manage, especially for inexperienced investors. It may require bringing on board a more experienced commercial real estate professional, either as an investor or manager.
- Potential for Conflict: Different stakeholders in the capital stack may have conflicting interests, which can lead to disputes over renovation, repair, refinancing, selling and other major decisions.
- Risk of Default: If the project fails to generate sufficient income, there is a risk that loans default. Investors may be unpaid or receive greatly diminished dividends in this situation.
How Does Capital Stack Affect ROI in CRE?
A capital stack plays a significant role in determining the potential return on investment (ROI) for a commercial real estate project.
On an individual level, where a loan or investment is within the stack affects both its potential return, and the probability that return will be paid. On a project level, how capital is sourced and weighted affects interest rates, dividends, profitability and overall returns.
Things to Consider Before Deciding What Capital Stack to Invest
Before investing in a commercial real estate project, it is crucial to consider several factors when evaluating the project’s capital stack:
- Investment Goals: Personal investment goals largely determine one’s risk tolerance, desired returns, time frame and other details. It’s important to understand how an investment’s position within a project’s stack affects risk, returns and decision-making input.
- Sponsor Experience: The track record and experience of the project sponsor are essential for assessing the risk and potential return of the investment. A large portion of the project rides on the sponsor’s expertise.
- Property and Market: The commercial stack shouldn’t be focused on the exclusion of the property itself. Investors ultimately invest in a property, and must understand that property and the current commercial real estate market.
Understanding the capital stack is crucial for anyone looking to invest in commercial real estate. By understanding the different components, their risk profiles, and how they affect returns, you can make informed decisions about which projects to invest in and how to structure projects.