Understanding the Real Estate Capital Stack
The capital stack in any investment opportunity or asset class basically includes all the money that can be involved in it. In terms of commercial real estate (CRE), it is one of the cornerstones of a great investment portfolio.
For an investor who is merely looking at the returns, the process of investment might appear as a simple input vs output equation. But a lot goes on behind the scenes to ensure that investments remain profitable. The capital infused in CRE comes from many sources and investors. Every investor will have a varying degree of propensity towards risks and returns w.r.t his/her investment. The capital stack is a representation of the types of capital invested in a CRE and the relationship among them. By relationship, I mean how the cash flow from the property is distributed, either during operations or during a transaction. As per the agreements signed, legal clauses indicate what each investor is entitled to when the cash distribution is done. The clauses also detail who is to bear the risk if additional capital is required for the project or pay interest if needed on any borrowed capital.
Understanding capital stack is important since it also explains risk, upside potential and downside protection a CRE investment might have. Capital stack indicates which investor receives priority of payment in case of a default or bankruptcy.
Let us explore how capital stack understanding can be used by investors to gain insights into how an investment opportunity is capitalized, and what would be their perfect fit as an investor within the cap stack. A sample stack shown in the figure below will illustrate the concepts I am talking about here. In many CRE investments, people tend to choose the lower stacks if they require more stability, while those interested in higher returns choose the upper racks. There might not be all the racks present in every CRE investment that you come across.
From among debt and equity, the capital stack can be further divided into four common tranches.
Equity: Investing via equity is one of the most heard methods when it comes to investing in CRE. It makes you a shareholder in the ownership of the property. Based on the invested amount, the investor owns a portion of the asset and earns regular returns. If the asset lives up to its promise, there is no cap on returns. However, on the flip side, you might be stuck with a very costly paperweight if the tenancy is not as expected. It is important thus to have great due diligence and financial analysis done in advance through a company that knows what it is doing.
- Preferred equity: It can be considered a hybrid between debt and equity; preferred equity can have qualities of both investment types. It comes with a ‘preferred return’ over common equity investors. Risk and return for preferred equity are higher than for mezzanine debt but less than for common equity.
- Common equity: Investors via common equity are the primary beneficiaries of any possible gains. This is a choice for those with higher risk tolerance, those who look forward to capital appreciation. The major downside to common equity is that investors have no guarantee to receive periodic payments or principal repayment. This makes it the riskiest layer of the cap stack while also offering the highest potential return.
Debt: Debt investing is simpler than equity. It involves lending the capital needed to purchase or develop an asset. Investors receive payments in pre-determined installments when everything is going according to plan. If there is a default, there is usually a path to recover the investments.
- Mezzanine debt: As the name suggests, this acts as a filler between mortgage-secured senior debt and equity. This debt is secured through the stock or the equity of the company that owns the property. The risk involved in mezzanine debt is higher than senior debt, and return expectations are higher.
- Senior debt: The most secure and protected layer of the cap stack. Investors here receive payments before any other in any layer. Senior debt is generally a mortgage that has collateral in terms of the property’s portions. This is mostly the largest layer of the stack. In the case of defaults, through foreclosure, the title to the property can be sold to recover the investment. There is a lesser risk to investors’ principal due to this. Returns are typically lower compared to other layers of the stack.
When working with Strata as an investor, your investment is done through fractional ownership that gives you access to the title of the asset through a special purpose vehicle. This makes your investment as secure as it can be while assuring great returns. To know more about how we work, please visit www.strataprop.com.