Capital Stack Real Estate: How Property Deals Are Funded

Commercial property transactions are commonly financed using multiple types of funding. Investors can use a combination of loan(s) and/or investment capital to acquire, construct, or enhance a commercial property. Each type of funding will have a different expense associated with it as well as varying levels of risk and repayment requirements.

The capital stack real estate is a term that refers to the different types of financing used by real estate investors when structuring a deal. Knowing about the Capital Stack can provide real estate investors with an idea of what kind of risk they are taking on, and what kind of financing options may be available for their project.

The Four Layers of a Capital Stack

A capital stack identifies where funds are sourced from and the order in which they are repaid. Lower layers of a capital stack are typically less risky than higher layers, and are repaid prior to higher layers. Higher layers within a capital stack can potentially yield higher returns, however they also represent greater risk.

Senior Debt

Senior debt is typically the largest loan that is used for a real estate transaction. Senior debt typically has first rights to be repaid and can be secured by the property being purchased. As a result of carrying less risk than other types of financing, senior debt also typically offers lower interest rates than other types of financing.

Mezzanine Debt

A mezzanine loan is designed to fill the financial gap that exists between senior debt and equity. Mezzanine loans are typically more expensive than senior debt, as they carry higher interest rates. If the borrower does not pay back the mezzanine loan on time, the lender may be able to take over some of the assets owned by the property-holding company.

Preferred Equity

Preferred equity is a type of investment capital that receives preferential treatment relative to common equity with respect to certain types of payments and/or returns. Typically preferred equity does not represent a typical loan, however it may include predetermined return objectives as well as other investor-related protections.

Common Equity

The equity that is invested in a real estate development project is the common equity. The common equity is typically paid after both the senior debt and the preferred equity have been paid off. There is more risk associated with common equity, but there is also a possibility of higher returns if the property does well.

A $10 Million Property Example

A commercial property may use this funding mix:

• $6 million in senior debt
• $1 million in mezzanine debt
• $1 million in preferred equity
• $2 million in common equity

Together, these funds provide the money needed to make the $10 million purchase. Exactly how the funding is made up depends on what type of real estate you are purchasing, the lenders terms, and your own investment goals.

Why the Capital Stack Matters

A well thought out capital stack real estate financing strategy can assist in balancing the cost of money with the level of risk. The greater the amount of debt, the larger the repayment obligation. If there is a decrease in rental income, or if costs increase, then the sponsor will find themselves in difficulty trying to satisfy their repayment obligations.

Investors should consider where they fall within the “stack” (repayment order), what type of repayment priority they have, and how much money they could lose prior to investing.

Build the Structure Around the Property

A deal will have its own capital stack real estate. A steady income producing rental property can take on more debt than a new construction project which will likely require more equity.

Prior to your investment, review the terms of the financing and the order in which you will receive your returns. An organized arrangement allows you to determine how money is put into the transaction and when you can expect to be refunded.