Real Estate Concepts - June 05, 2024

Capital Stack: How It Works, What to Know

June 05, 2024

Abby Blumenfeld
By Abby Blumenfeld

The capital stack is a cornerstone commercial real estate investing and finance concept. Imagine you’re about to embark on a thrilling archeological dig, and you’ve been handed a map. The map in your hands is the key to understanding where the most valuable treasures lie and how to reach them safely.

In the world of passive real estate investing, the capital stack is your treasure map. It reveals the layers of investment opportunities, each with its own risk-reward profile, waiting to be discovered. While the mechanics of the capital stack (or “cap stack”) may appear complex at first glance, you’ll soon realize that the capital stack structure applies fairly reliably to all commercial real estate transactions. This framework is essential for investors to grasp this concept to evaluate risk, understand repayment structures, and make informed decisions about their investments.

“The Cap Stack” Key Takeaways

  • The capital stack is a sequence of financial instruments that collectively finance a real estate transaction or project.
  • Each position in the cap stack holds certain characteristics in terms of payment priority, rights, and return potential.
  • As an individual passive investor, you can take part in various positions in the cap stack…
  • …as such, it is important to understand the risks, return potential, and rights of your investment entails.

The cap stack is one of the first things a sponsor (the managing party) thinks about when embarking on a real estate investment. If you are investing passively is real estate (as an LP), you won’t be responsible for compiling the capital stack. However, you’ll still want to understand the underlying mechanics and where your investment sits in the capital stack. This guide demystifies the capital stack and delve into how it influences investment strategy, with a particular focus on opportunities available through EquityMultiple, enriched with detailed examples, statistics, and case studies to provide a thorough understanding.

cap stack in real estate example

A trip down memory lane: a visualization of the capital stack from an early EquityMultiple investment opportunity

The capital stack refers to the structure of all the capital invested in a property, including the different types of debt and equity and the relationship between lenders and investors in order of priority. It’s a critical part of the real estate investing process, one that any self-directed real estate investors should be intimately familiar with.

Before we begin, it’s worth pointing that your position in the capital stack is a huge determinant of the risk-return profile of a real estate investment, and what degree of protections you’re afforded as an investor. Think of it as a sliding scale, with the highest risk and highest return at the top and the lowest risk and lowest return at the bottom. (A layer cake is also a good metaphor.)

Let’s dive in.

Intro: What Is the Capital Stack?

The “capital stack” refers to the full set of financing instruments used to fund a given real estate investment.

Every homeowner understands the difference between their mortgage and the equity they have in their home. However, commercial real estate financing can be more complicated, involving numerous parties and a variety of instruments, some of which have risen in prominence over the past few decades. We’ll demystify all of these intricate pieces of the capital stack throughout this article.

The capital stack is particularly relevant for individual investors, as modern real estate investing platforms allow for fractional investing at various positions in the capital stack. One of EquityMultiple’s hallmarks is easy access across the capital stack via our three pillars: Keep, Earn, and Grow.

Even experienced investors may benefit from reviewing the capital stack again, and looking into the material differences between equity, preferred equity, mezzanine debt, and senior debt.

Capital Stack Definition

The capital stack refers to the full set of financing instruments in a commercial real estate transaction, including various potential forms of debt and equity. Among real estate professionals, capital stack may be referred to short-hand as the “cap stack.”

Much like a single-family home purchase, a real estate investment firm (a “sponsor”) will often seek a loan from a large bank at an attractive interest rate, subject to the bank’s underwriting and leverage standards. The sponsor will also contribute some amount of their own capital in the form of equity. In order to reclaim capital for other purposes, or to meet the capital requirements of the project, the sponsor will seek additional financing in the form of debt and/or equity to close the gap between total forecasted project cost and the financing already on-hand from a bank loan and/or their own capital.

This overall financing structure — the capital stack — can reflect an infinite number of variations to suit the requirements of the sponsor, the project, and additional investors. Especially for larger commercial real estate transactions, the capital stack may be complex – with multiple tranches of mezzanine debt or senior debt that are later syndicated out into multiple notes. Even taken by itself, the equity component of the capital stack may be arranged in complex waterfall payment structures and return hurdles. 

The 4 Key Components of the Capital Stack

As an individual passive real estate investor, you won’t be responsible for compiling a capital stack for the deals you invest in. However, it’s critical to understand where you are investing in the capital stack with any given investment. This article looks at the four components of the capital stack you’re most likely to encounter when investing through an online real estate investment or crowdfunding platform, going from the least to most risky: senior debt, mezzanine debt, preferred equity, and common equity

real estate capital stack overview

Senior Debt

Senior debt is secured by a mortgage or deed of trust on the property itself; if the borrower fails to pay and defaults on the loan, the lender is entitled to take title to the property. This greatly reduces risk on the principal invested because, at worst, the lender owns the property and will look to maximize value by selling the property or selling the non-performing loan. The “cost” of this lower level of risk is a lower yield on the money invested. Senior debt investors will be entitled to lower returns than all higher positions in the capital stack, over whom the senior debt investor will have payment priority. To properly understand the risk involved, look at the loan-to-value (“LTV”) ratio of the loan – if the loan has a 60% LTV there is a lot more margin for error than an 85% LTV loan. It’s a simple analysis: in the worst case scenario, as the lender, you’d much rather end up owning the property at 60% of its value than 85%.

As with any commercial real estate investment, senior debt investors will want to take a close look at the sponsor’s (i.e. the borrower’s) ability to service their debt obligation. The debt service coverage ratio and total leverage should come into focus. Real estate investing platforms may offer senior debt investments as a direct line of capital to the borrower, such that individual investors are effectively lending to the sponsor. The platform may also “syndicate” a pre-existing loan from a lender – so that individuals are passively investing alongside a private CRE lender. In either case, individual investors should consider the experience and track record of both the borrower (sponsor) and the lender, be that the platform itself or a separate private lender.

In 2024 and beyond, we expect significant opportunity in real estate private credit (otherwise known as CRE debt investing). This opportunity hinges on current macroeconomic factors, but as always this position of the capital stack enjoys payment priority and downside protections. EquityMultiple’s Ascent Income Fund was established to bring the current opportunity to individual investors.

Capital stack 2 graphic

Examples of senior debt investments on EquityMultiple.

Mezzanine Debt

Mezzanine debt sits below the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the fixed coupon of the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called an intercreditor agreement, in which they spell out how their rights interact (i.e., what happens if a developer stops paying both of them). Mezzanine debt typically has a higher return rate than senior debt but lower than that of equity.

In cases where the capital stack includes both mezzanine debt and preferred equity, mezzanine debt typically carries payment priority over preferred equity and consequently offers a lower rate.

mezzanine debt in the capital stack

For more on mezzanine debt, how it is used, and the particulars of investing at this point in the capital stack, please refer to this article.

Examples of mezzanine debt investments on EquityMultiple.

Preferred Equity

Preferred equity is perhaps the hardest portion of the capital stack to speak about generally because, for better and worse, it’s very flexible. Preferred equity holders have a preferred right to payments over regular (common) equity holders. “Pref” equity positions range from “hard” preferred equity, which function similarly to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or remove the borrower (the sponsor or developer) if they fail to make payments, soft preferred equity holders typically have more limited rights. As you’d imagine, the rate of return for hard preferred equity is similar (or slightly better) than mezzanine debt, while soft preferred equity returns can be substantially better.

Preferred equity investors are entitled to returns that are paid prior to common equity holders receiving distributions (this is the “preferred” in preferred equity). Because of this as well as recourse that preferred equity holders may have in the event of a borrower default, preferred equity is considered less risky than common equity, and hence preferred equity investor’s entitled to upside will be capped.

preferred equity in the capital stack

Preferred equity and mezzanine debt fulfill similar functions in the capital stack: forms of “bridge financing” – methods of financing short-term capital needs to fill a gap between the debt and equity components of the overall project’s capitalization. Both entail some recourse provisions for the holder of the position.

For more on the benefits of preferred equity real estate investing, and how it is used in the capital stack, please review this article.

Examples of preferred equity investments on EquityMultiple.

Common Equity: The Top of the Capital Stack

Common equity is the riskiest and most profitable portion of the real estate capital stack. Typically the GP investor (the developer or sponsor) will be required – by the lender and/or by other equity investors – to invest their own money as some portion of the equity to have skin in the game. Equity investments carry the greatest risk, because investment agreements entitle every other tranche of capital to be repaid before common equity holders. However, if the property performs well, equity investors usually have no cap on their potential returns. In real estate, equity is typically structured so that all investors earn a preferred return until they hit a certain annual return hurdle (i.e., 8%). After that, the developer or sponsor will earn a disproportionate share of the profits (i.e., 40% of all the remaining profit), while investors receive the rest of what’s left pro rata. For more on preferred returns in real estate, please refer to this article.

common equity

Though common equity is generally the highest-risk, highest-upside portion of the capital stack, not all common equity investments are created equal with respect to their risk/return profile. A healthy preferred return written into an investment agreement can mitigate some downside risk for passive investors (we typically strive to negotiate attractive preferred returns on behalf of EquityMultiple investors).

Examples of common equity investments on EquityMultiple.

What Else Impacts Risk and Returns?

Other qualitative and quantitative attributes of equity investment opportunities can impact the attendant risk and potential upside. Some of these factors include:

  • Capitalization Rates: how conservatively the exit (or “going out”) cap rate is modeled. For more, please review this article.
  • Market: Generally, gateway markets like New York City or San Francisco will offer more downside protection (less risk) but, accordingly, less upside potential. This is because dense, affluent knowledge centers such as these enjoy robust and diverse rental demand but are hence home to some of the most competitive real estate markets in the world, dampening return potential. It’s no coincidence that markets like New York City become particularly appealing for global investors in times of economic volatility. Conversely, lesser-known secondary and tertiary markets may offer more robust demand growth opportunities, and upside for commercial real estate investment, but higher risk due to less established, less diverse local economies.
  • Business Plan: Equity investments can offer an array of risk/return profiles based on the underlying strategy. The amount of capital expenditure needed, the complexity of the project, and the in-place rent roll and cash flow all impact the risk and potential return of an investment. For more on this topic, please review this article.

Such considerations matter for investments throughout the capital stack. However, such attributes of an investment can magnify risk and return potential for a common equity investment to a greater extent, as passive investors have fewer protections but can enjoy uncapped upside.

capital stack example

The capital stack of a prior preferred equity investment, showing total capitalization and relative proportions of debt and equity capital.

The Bottom Line – The Capital Stack and Your Portfolio

Understanding the capital stack isn’t just about knowing where your money sits – it’s about empowering yourself to make informed decisions that align with your financial goals. Whether you’re seeking the steady income of senior debt or the upside potential of common equity, the capital stack offers a position for every investor. Understanding the different investment structures across the capital stack is critical to creating a diversified real estate portfolio that fits your strategy. Much like investing in stocks and bonds, how you allocate between equity and debt real estate investments should depend on your investment goals and strategy, including your risk tolerance. For risk-tolerant investors, heavier exposure to real estate equity may be more appealing. By the same token, risk-averse investors may find the relative security and short terms of senior debt or mezzanine debt more appealing. While studies repeatedly show that “timing the market” is next to impossible, even for experienced investors, timing considerations can also help guide portfolio strategy.

In high interest rate environments, diversification across investment structures and target hold periods is all the more critical. Strain on credit markets may generate opportunity for private lenders, and hence senior and mezzanine debt opportunities, while demand dislocations may create a new universe of value-add opportunities for common equity investors.

Here’s a current breakdown of EquityMultiple investment opportunities by capital type:

Following years of a bull market where attractive equity investment opportunities became increasingly scarce, recent rate cuts and the resulting shifts in the global economy are likely to generate a broad spectrum of new opportunities across markets and the capital stack. As new debt and equity capital needs arise, investors may benefit from a diversified approach for both their real estate portfolios and their overall investment strategy. By distributing commercial real estate investments across the capital stack, investors can potentially manage risk exposure while still aiming for long-term appreciation and upside.

Up Next >>> Commercial Real Estate Due Diligence

 


The Real Estate Capital Stack — FAQs

Q: What is the safest investment in the capital stack?
A: Senior debt is considered the safest investment due to its priority in repayment. It’s akin to a secured loan that must be repaid before any other investors receive returns.

Q: Can I lose my investment if I’m in the common equity layer?
A: Yes, common equity carries the highest risk, including the potential for a total loss of investment. However, it also offers the potential for the highest returns, reflecting its risk-reward balance.

Q: How does preferred equity differ from common equity?
A: Preferred equity offers a fixed return and sometimes profit participation, with repayment priority over common equity. It’s less risky than common equity but offers higher potential returns than debt investments.

Q: Why is the capital stack important for real estate investors?
A: The capital stack provides a framework for understanding the risk and repayment structure of investments, enabling informed decision-making aligned with financial goals and risk tolerance.

Q: How can I diversify my investment across the capital stack?
A: Investors can achieve portfolio diversification by allocating capital across different layers of the capital stack, such as mixing senior debt with preferred or common equity investments. This strategy balances the overall risk and return profile of the portfolio.

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Abby Blumenfeld
Abby Blumenfeld
Abby Blumenfeld is the Senior Investor Relations Analyst at EquityMultiple. Originally from Massachusetts and a graduate of Quinnipiac University, Abby has an extensive background in both commercial and residential real estate. Before joining EquityMultiple, she gained experience working with commercial properties at Cushman and Wakefield. Her experience includes both the New York City and Boston real estate markets. At EquityMultiple, Abby is responsible for developing relationships with prospective investors, ensuring clear communication, and serving as the primary point of contact for investors. If you reach out to EquityMultiple, there’s a good chance you’ll interact with Abby during your journey. Outside of work, Abby enjoys playing pickleball, tennis, and traveling.

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