What is the capital stack in real estate?
The capital stack in a real estate project refers to the different financing sources used to fund the venture. Real estate financing typically involves a mix of debt and equity. These are the two broad sources comprising the commercial real estate capital stack. Each of these two sources of finance can be further subdivided.
Common equity investors and preferred equity investors contribute to the equity component in a real estate investment. The debt component in the capital stack is generally categorized as senior debt and mezzanine debt. Therefore, the four capital stack real estate divisions could be listed as follows:
- Common equity
- Preferred equity
- Mezzanine debt
- Senior debt
Commercial real estate professionals use the capital stack to learn about the profitability and risks involved in a property investment when different types of capital are used.
Note: Do not confuse the capital stack with stacking plans. The latter is a visual representation of a commercial structure’s floor-wise use.
How does the capital stack work in real estate?
The capital stack informs real estate investors about the different financing layers that go into a commercial real estate investment. Each component of the capital stack carries a different risk level, and the returns differ, too.
Equity investors bear a higher risk, but the upside is that they can earn higher returns on commercial real estate investments. Debt investors earn lower returns than equity investors. However, the level of risk they are exposed to is lower too.
4 layers in capital stack funding structure
Let us take a closer look at each of the four layers in a capital stack:
1. Senior debt
In a commercial real estate deal, senior debt is typically provided by a commercial bank. Senior debt lenders are exposed to the lowest level of risk in the capital stack and earn the lowest returns.
In the event of a borrower’s default on the repayment of principal or interest, senior debt holders have first right on the property. A senior debt lender could insist on a high down payment to reduce the level of risk they are exposed to. An increased down payment implies a lower loan installment payment by the borrower and consequently, a reduced risk of default.
2. Mezzanine debt
Lenders in this category generally earn a higher rate of return than senior debt lenders. However, mezzanine debt is less secure than senior debt. Senior debt lenders have first right over the cash flows from the property. Mezzanine holders have a lower payment priority than senior debt holders.
3. Preferred equity
Preferred equity lies midway between mezzanine debt and common equity in the capital stack. It can be crucial in financing a commercial real estate deal if the common equity and debt are insufficient to pay for the property being purchased.
Preferred equity investors are typically paid a guaranteed rate of return. Additionally, preferred equity holders get a higher priority in repayments than those holding common equity in the project.
4. Common equity
Common equity investors undertake the greatest risk in a real estate investment. However, they can gain the most as they are entitled to all the cash flows from the project after the others in the capital stack have been paid off.
The project sponsors contribute part of the common equity. They raise additional common equity from their investor partners. The sponsors are responsible for all operational activities and ensure that the cash flows generated by the project are paid to the senior debt holders, mezzanine lenders, and preferred equity holders in that order. The holders of common equity investments are paid last.
Structure of the capital stack
| Capital stack component | Debt or equity | Description |
| Senior debt | Debt | Has the highest stake in the project and the first right to the property in the event of foreclosure. Earns a low return. |
| Mezzanine debt | Debt | Less secure than senior debt but earns a higher interest rate. |
| Preferred equity | Equity | Earns a guaranteed rate of return and gets a higher payment priority than common equity. |
| Common equity | Equity | Common equity is contributed by the sponsor or developer and other common equity investors. It has the last right to the cash flows in the capital stack. |
How to analyze the capital stack in real estate
Closely examining the capital stack can provide real estate professionals with deep insights into a project and help them devise their real estate investment strategies. For example, if senior debt contributes 80% of the project cost, it may be safe to assume that the commercial property can generate sufficient income to meet its debt obligations.
How can you come to this conclusion?
The commercial bank advancing funds would have carried out extensive due diligence and would be convinced that the property’s credit profile justified the high loan-to-value ratio. A lower loan-to-value ratio may be an indication that, in the opinion of the commercial bank, the project exhibits limited creditworthiness.
Capital stack calculation example
A developer identifies a property that requires a $15 million investment. The developer contributes $300,000 and raises $1.2 million from other common equity investors. Therefore, the total common equity in the project is $1.5 million ($300,000 + $1.2 million).
A commercial bank agrees to provide a $10 million loan. The loan is secured by the property and forms the senior debt component of the capital stack. The developer raised mezzanine debt of an additional $1.8 million from a real estate debt fund to renovate the property. The loan has a higher coupon rate than the senior debt.
A private equity fund agrees to provide $1.7 million as preferred equity. This is what the capital stack will look like:
- Senior debt: $10 million
- Mezzanine debt: $1.8 million
- Preferred equity: $1.7 million
- Common equity: $1.5 million
How to do the capital stack ratio analysis
Let us examine some ratios you can use to analyze the capital stack. Reviewing these ratios can help you better understand the risks involved in the commercial real estate proposal.
Loan-to-value ratio (LTV)
The loan-to-value ratio is the ratio of the mortgage amount to the appraised property value.
- LTV ratio = Mortgage amount / Appraised property value
Senior debt lenders can use the LTV ratio to determine the level of risk in a commercial real estate proposal. A higher down payment results in a lower ratio, signifying greater security for the lender.
Debt yield (DY)
The debt yield ratio compares the net operating income from the commercial real estate property to the total loan amount.
- Debt yield ratio = Net operating income / Total loan amount
A lower ratio signifies higher credit risk, while a higher ratio indicates the opposite. In other words, the lender would face a lower level of risk if the property has a greater net operating income (for the same loan amount).
Debt service coverage ratio (DSCR)
The debt service coverage ratio (DSCR) is the third ratio for real estate capital stack analysis. It tells you if the property generates adequate income to service the debt burden.
- DSCR = Net operating income / Annual debt service
A high DSCR indicates a greater level of safety for lenders.
Real estate capital stack analysis – the ratios to use
| Ratio | What the ratio tells you |
| Loan-to-value ratio | Ratio of the loan amount to the property value |
| Debt yield ratio | Ratio of the NOI to the loan amount |
| Debt service coverage ratio | Ratio of the NOI to annual debt service |
Benefits of a capital stack
Examining the real estate capital stack can provide useful information to commercial real estate professionals. Here are some of the details you can gather:
- Efficient capital utilization: Real estate investors can deploy their funds in different parts of the capital stack across several commercial real estate properties. This can help them minimize losses while investing in properties with the greatest return on investment.
- Risk diversification: Studying the capital stack can help you match your investment goals with the risk profile of your investments. For example, common equity investments are a good match for those who can bear a high degree of risk, as common equity holders are at the riskiest end of the capital stack.
- Access to flexible financing options: Borrowers have a range of options. Mezzanine debt lenders and those investing in preferred equity are usually more flexible when advancing funds than the financial institutions providing senior debt.
- Flexibility in financing large-scale projects: Property developers and sponsors have four ways to raise funds: senior debt, mezzanine debt, preferred equity, and common equity. This breadth of choice can be invaluable for large projects where the developer needs help to raise the required funding.
How the capital stack can help real estate investors understand risk
The capital stack for a commercial real estate project gives real estate investors a clear idea about the level of risk they are undertaking and the return they can expect to make. That is to say, the capital stack can help investors overcome one of the most significant commercial real estate challenges – balancing return and risk.
Let us take a closer look at how this works:
- Risk hierarchy in the capital stack: The capital stack can provide real estate investors with an explicit understanding of their position in the risk-return hierarchy.
- Foreclosure implications for senior debt lenders: Senior debt lenders are at the safest end of the capital stack. In the event of a borrower’s default, they have the right to foreclose on the property to recover their dues.
- Challenges for mezzanine debt and preferred equity holders: Mezzanine lenders and preferred equity holders are exposed to greater risk than senior debt lenders. As compensation, they earn a higher return on their real estate investment.
- Owner equity risk exposure: Common equity holders are exposed to the highest degree of risk. They are paid only after all other investors’ dues have been settled. However, they gain the most if the property generates the expected, or greater than expected returns.
- Market downturn effects on layered financing: In a market downturn, a senior debt lender may be unable to recover its dues. That said, there is a way for senior debt holders to protect themselves. A project with a low LTV ratio can offer them a better chance of exiting the transaction without incurring losses.
Best practices for structuring a capital stack
Here are some best practices to follow when deciding how to raise funds for a commercial real estate project:
- Layering debt for complex projects: Senior debt accounts for most of the project cost in the vast majority of property deals. However, there could be instances when the layering needs to be done differently. Consider, for example, a project involving extensive refurbishment of the asset. The most appropriate funding arrangement here may involve higher mezzanine debt or preferred equity, and a lower volume of senior debt.
- Understanding repayment priority: The capital stack describes the four broad layers of funding that comprise a property deal. Common equity has the lowest priority, and senior debt has the highest. The other two layers of the stack lie between these two finance modes.
- Tailoring the stack to project scale and complexity: Several factors determine the composition of the capital stack. Among the important ones are:
- The risk involved
- The size of the project
- The timing of the requirement for funds
- The requirements of the investors
The sponsors of the project need to take all these factors into account when deciding on their funding mix.
- Balancing debt and equity for long-term growth: Developing the capital structure for a property deal involves finding the right mix of debt and equity. The developer’s objective is to minimize costs while raising adequate funds to complete the project.
How to determine an optimal capital stack
There is no one-size-fits-all solution for creating the capital stack for a commercial real estate project. A developer must consider various factors when deciding on the optimal combination of debt and equity to raise. The factors to be considered include:
- Market conditions
- Interest rates
- The sums investors are willing to provide
- The creditworthiness of the project
The bottom line
The capital stack of a real estate project provides crucial information. It tells investors where they stand in the repayment hierarchy and helps them decide if the returns they make are commensurate with the level of risk their investments are exposed to. They should remember that conducting a comprehensive and intensive review of the capital stack is essential before deciding on an investment opportunity.
