The commercial real estate capital stack is an organizational model that outlines a commercial real estate project’s hierarchy of capital contributions. The stack is split between debt and equity investments with the lowest risk and lowest return investments at the bottom of the stack and the high-risk high return equity investments at the top. The capital stack is a useful analytical tool for commercial investors.
The foundation of the capital stack represents a deal’s debt contributions. These lenders have priority and will receive payments first when the property generates sufficient cash flows. The debt section is split between senior debt and hybrid mezzanine debt.
Senior debt typically funds around 75% of a project’s total cost and can be a more secured position in the capital stack. Senior debt lenders will receive their payouts first before any other investor and are usually mortgage lenders. Mortgage lenders have the benefit of retaining the real property asset as collateral on their investment.
Mezzanine debt is a hybrid debt that is second to senior debt in priority but offers lenders certain other benefits. A relationship between the senior debt lender and the mezzanine lender is outlined in a written instrument where the parties will establish the mezzanine loan’s subordination to the senior lender’s mortgage and define the respective rights and obligations of the parties.
The most important distinction between senior debt and mezzanine debt is the securitization of the respective loans. The senior lender will typically be secured by the real property asset through a mortgage while the mezzanine debt will be secured by a lien on the membership interest in the entity that owns the real property asset.
Debt investing offers the lowest associated risks in the capital stack. In the event of a default, senior and mezzanine debt investors can have a considerable chance of recovering their initial investments through liens on the collateral.
Equity investments are at the top of the capital stack and are accompanied by both great risk and potentially lucrative rewards. An equity investor typically purchases a percentage of equity in the corporate entity holding the project’s real property assets. Equity investing is split into two categories in the capital stack, preferred equity, and common equity.
Common and Preferred Equity
Common equity sits at the top of the capital stack and typically represents the contributions made by the project’s interested parties. Equity investors will receive periodic payments in the form of dividends if the property is generating adequate cash flow. The term preferred equity refers to those investors who assume less risk by having payment priority over common equity holders. Although preferred equity can also be accompanied by other various agreed-to benefits such as enhanced voting rights and corporate management controls.
Unlike debt investors, equity investors have no means of securing their investments and have no guarantee of a return on their principal contribution. Despite the lack of security, equity investors could realize returns on a lucrative project.