Understanding The Real Estate Investment Capital Stack for Passive Investors
Have you ever had Belgian waffles before? If you haven’t, I want to inform you that they are devilishly delicious. Especially when you stack them on top of each other, fluffy waffle after fluffy waffle, drizzle on your favorite maple syrup, some fresh fruit and a dash of powdered sugar and, if you really want to indulge, some whipped cream.
OK you can wipe the water from your mouth.
Financing real estate investments is a lot like Belgian waffles. OK, they may not make your mouth water, but I digress. So how are they they similar? Allow me to introduce you to the capital stack; the layers of funds (i.e. money) used to finance a real estate investment.
Defined: The Capital Stack
Capital refers to money used in an investment.
The capital stack of a real estate investment is the composition of all the different means/sources of funds used to finance a transaction and the related rights (and responsibilities) to income/profits (or losses/obligations) generated by the investment and the ownership of the property.
Why the Capital Stack Is Important For Passive Investors
One of the must ask questions when deciding to passively invest in a real estate offering is “how is this deal financed?” The position on the capital stack is highly important for a passive investor to understand. Knowing where your capital falls on the capital stack helps you to understand the risk and rewards, rights and obligations you have as an investor. With capital preservation being a prime investment criteria, understanding the capital stack gives you a clear understanding of what happens in worse case situations; what happens if the investment doesn’t perform and there is some default?
One of the must ask questions when deciding to passively invest in a real estate offering is “how is this deal financed?”
4 Pieces of the Capital Stack
The complete capital stack is comprised of the following 4 pieces: Senior Debt, Mezzanine Debt, Preferred Equity and Common Equity. While all deals may not have all 4 pieces of the capital stack you will have at least 1 piece and more commonly one layer of debt (loan given to ownership usually for a fixed period and contractual obligation for defined payments) and one layer of equity (ownership interest). For reasons such as improved returns from using leverage, facts and circumstances connected to the property, risk management or investment vehicle used, investors may choose to structure their capital stack with whatever mix provides the most advantageous outcome.
This is probably the most well know piece of the capital stack. All though it is at the bottom of the capital stack it is one of the most advantageous positions to be in. You may know of senior debt more familiarly as a mortgage with first lien position on a home. As this debt is more “senior” it has more rights to the cash flows and income generate from the property.
Typically, senior debt will be first position lien debt for which an interest rate is charged on the funds borrowed. It is usually the largest layer of the capital stack and “secured” as the property is collateral for the loan. This senior debt will be paid before any other pieces of the capital stack receive payment. If the property were to go into default (i.e. inability to pay the senior debt), then the senior debt holder would be entitled to take possession of the property via foreclosure processes. For what the senior debt position gains in their security of payment they lose in opportunity of upside of the deal. Lower risk, lower reward.
The payment of the senior debt is what investors refer to as debt service. The next piece of the capital stack may also be covered in the debt service.
Mezzanine or Junior debt holders take on a bit more risk than senior debt holders as they only get paid after the senior debt holders. In the case of default, mezzanine debt holders are limited to what rights they can claim on a property subordinate to senior debt holders. As there is slightly higher risk, mezzanine debt holders usually require higher return compared to senior debt holders.
As mezzanine debt is still debt, they are owed a set payment regardless of the property’s performance. This is different than the next two levels of the capital stack which are comprised of equity.
The next level of the capital stack is preferred equity. As we transition into the equity holders of this layer of the capital stack are no longer “guaranteed” their return. Holders of equity only get paid after the debt is paid; if the property can not cover the debt payments, equity holders may have an obligation to cure the default, pay the unpaid debt, and may even lose their initial investments.
It’s not all that bad however. Equity investors are owners of the investment and get the opportunity to enjoy the upside in the investment of a property and all the tax benefits and other benefits that come with ownership. That means there is unlimited potential for the return that these equity holders may receive. As you can imagine with more risk there is an expectation of more reward.
Equity comes in two flavors, one of them acts a bit like debt – preferred equity. The owners of preferred equity, while they have no guaranteed payments, are first in line after all the debt holders and before the final piece of the capital stack, common equity. Preferred equity holders get preferential treatment before other equity holders (and may even give up some upside to get that perk.) Only after the preferred equity holders are paid do the common equity holders get paid.
Common equity is the last piece of the of the capital stack and has the highest risk but also the highest reward. Common equity holders get paid after everyone else and will have an unlimited upside in the earnings that the property produces after paying all the other layers of the capital stack. The returns that common equity holders receive can double, triple or quadruple the returns obtained by other layers of the capital stack but it also comes with the risk of getting nothing at all.
Common equity and Senior debt are the two most popular layer combinations of the capital stack. Going back to our senior debt mortgage on a house. The common equity would be your down payment on the house. You may add some mezzanine debt if you do a refinance to access some equity or take out a home equity line of credit on the house for second position lien debt.
Stacking It All Together
An ideal capital stack for one project at a certain point in a market cycle may be different for that same property at a different point in a market cycle. The financing of a real estate project can make or break the way the investment performs and the returns that the investment produces. Even more important, your position on the capital stack impacts the amount of return you can expect to earn. When you know your real estate investing goals and risk appetite you can decide what type of investments and position in the capital stack most fits your profile.
Do you want relatively secure consistent cash flow with no upside? Maybe investing via debt opportunities is for you. Prefer out-sized returns with an appetite for risk? You may be more of a common equity kind of person. Or maybe you want to have a little bit of both? Why not have your cake, or should I say waffles, and eat it too? Then maybe the mix of preferred equity is more your flavor.
When an investment goes well everyone gets paid. If things don’t go as planned however it is important to know where you will be before you invest. Whatever your goals are, identify your ideal position in the capital stack and enjoy the returns that follow.
Until then, can somebody pass me the syrup?