What Is A Capital Stack?
The capital stack is one way of evaluating the risk in a commercial real estate investment. It’s called a stack since it refers to the different layers of financing for the purchase or renovation of a commercial income property.
In order to understand how a capital stack works, picture a pyramid. At each level of the pyramid is a lender who has invested equity in the property.
A lender’s position on the pyramid determines their lien position. So if the lender is on the bottom of the pyramid, or the stack, then in the event of a sale or refinance their first position place gives them first rights to the money that comes in. Once they have been paid off in full, the lenders above them will receive their share of the income and profits that come in.
In the case of a default, the lender on the bottom stack has first rights to the property. In the event that there is not enough money to repay all the loans, the lenders on the top of the stack will be hit the hardest, as they will not receive their share of any income or profits until everyone on the level below has received their share.
Thus, each lender is subservient to the lender on the level below and supersedes the lenders that are on the stack above.
Why Are Capital Stacks Important?
A capital stack allows investors to visualize where they fall in terms of receiving any income or profits from the investment property.
The higher up on the stack, the higher the risk. There is no better or worse place to be on the capital stack; an investor’s position on the stack will depend on the level of risk they are willing to assume in order to achieve returns.
As a lender’s position increases so does the potential for higher returns. Thus a capital stack will also help an investor determine whether the higher potential for profit justifies the risk. In fact, investors will often choose to invest in different levels of the stack in order to spread risk and generate higher returns.
Senior Debt, Junior Debt, And Mezzanine Debt
Senior debt holders don’t have it as bad as it seems. As long as the property generates enough of a cash flow to pay back the principal, they receive payments before anyone else on the stack. The same holds true for when a property is sold: they not only get the principal but interest as well.
In the event that the property performs poorly, senior debt holders have the right to start the foreclosure process, taking over ownership and selling the property in order to recover as much of the investment as possible.
Further up in the capital stack are other forms of debt, such as mezzanine debt (junior debt), preferred equity, and common equity. Mezzanine debt, which is also called hybrid debt, is next on the stack after senior debt. In its simplest form, it is a subordinate loan that increases leverage on the property, though it is not always secured by a second mortgage.
In other instances, mezzanine lenders receive a pledge of ownership interest. While some mezzanine holders have rights to foreclosure, any actions taken by the mezzanine debt holders must be approved by the senior debt holders first. In terms of income and profits, mezzanine debt holders are above senior debt holders on the stack, and therefore receive higher returns in exchange for the increased risk inherent to their position.
Above mezz holders are preferred equity holders. As the term indicates, preferred debt holders receive a higher return than mezz holders, but less than common equity holders, who sit at the top of the stack. Both preferred debt holders and common equity holders receive returns that can go up or down depending on how well the investment property performs.
However, because equity holders are also owners, there is no set period when their investment will be returned; only when the property is sold or another investor (on any level of the stack) sells out their interest do they receive a full payout.
The capital stack presents numerous opportunities for both buyers and sellers. Used wisely, it will allow investors to build a diversified portfolio that experiences steady growth.