Understanding what a capital stack means and how it affects your place in an investment can make the difference between losing all of your money and retaining your assets in the event that things go wrong.
The capital stack represents the different types of assets invested in a commercial property, it also determines which investors have legal rights to that asset and its profits.
Although the capital stack can be divided into several categories, each stack typically falls into three categories:
- Debt, which is on the bottom of the stack.
- Preferred equity, or mezzanine, which is in the middle.
- Common equity, which is on the top.
Debt is loan money used to fund an investment. It is secured by the commercial property itself or through another property owned by the borrower, and it considered to be the safest form of debt. Since this form of debt can often be financed for up to 70-75% of the price of the commercial property, it also has the potential for higher cash on cash returns, because it allows an investor to purchase a more expensive property.
Debt can be broken down into three types:
- First Mortgage Debt
This is a conventional mortgage, and is usually the most difficult source of capital to get. Based on either a fixed or adjustable interest rate, it is usually given by banks, pension funds, and credit unions, a lien is usually placed on the property as security for the debt owed.
- Second Mortgage Debt
Available from private lenders and development agencies, these is capital comes which comes at a higher price. Loan rates are higher than with a conventional mortgage, and generally fall in the range of 8-12%.
- Asset Based Debt
Asset based debt is generally a hard money loan funded by companies or private investors. Interest rates are higher than rates for a second mortgage debt, typically ranging from 11 to 14%.
Equity owners are at the top of the stack, and as such are in the riskiest position. It’s their responsibility to make sure that everyone underneath them – the banks, private lenders, and hard money lenders- gets paid first. As a result, they get paid last.
On the other hand, higher risk also means a potentially higher payout, as equity owners’ profits are made from the performance of the commercial real estate investment itself.
PREFERRED EQUITY/MEZZANINE DEBT
Preferred Equity, in the middle of the stack, is a hybrid of debt and equity. Mezzanine debt is a short-term, higher-risk loan, and typically has an interest rate around 2-3% higher than the bottom stack debt owners. The structure of a mezzanine debt is often a mix of equity and debt, since the return can be structured for investors to receive a fixed annual payback over a set period of time, or as a payback in terms of investment performance.
Keep in mind that the structure of the capital stack differs depending on the deal, and thus the potential risk and returns may vary depending on the deal. It is your job as an investor to make sure you understand exactly what your responsibilities and your options are, and that you have a clear understanding of what returns you’re entitled to receive.