Before making an investment in any asset class, it’s critical to complete a thorough due diligence process. This is certainly true in commercial real estate. One important component of the due diligence process is understanding how an investment’s place in the capital stack (or “cap stack”) plays an important role in evaluating and comprehending risk, and measuring the appropriate return.
Most commercial real estate projects receive capital from multiple sources and from investors who have varying risk and return goals and expectations. A capital stack represents the different types of capital invested into a commercial real estate asset and the relationship between each type, specifically regarding how cash flow from the property is distributed from operations and upon a capital event. Legal documents spell out what each investor in the capital stack is entitled to, in terms of when cash is available for distribution and who bears the risk if additional capital is required to fund the project or pay interest on borrowed capital.
Importantly, the capital stack also reflects who receives priority of payment in the event of a default or bankruptcy. Therefore, understanding your place in the capital stack is critical when assessing how much risk, upside potential, and downside protection a commercial real estate investment may have.
In this article, we’ll discuss the most common tranches or layers of the capital stack. We’ll also explore how investors can use the capital stack to understand how an investment opportunity is capitalized, and where they might be most comfortable investing within the cap stack.
Let’s start by looking at a sample capital stack with layers that investors are likely to come across when considering commercial real estate. Note that seniority increases as you move from top to bottom, while risk and return decrease from top to bottom. Most real estate investments include some combination of the tranches of capital highlighted below.
The capital stack is divided into two main categories — debt and equity — then sliced again into more specific types.
Debt: Debt investing involves lending the capital needed to purchase or develop a property. When everything is going according to plan, investors receive payments in pre-determined installments. In the event of a default, debtholders generally have a path to recover all or part of their investments.
- Senior debt: Senior debt is the most secure, protected layer of the capital stack. Investors in this layer receive payments before any other capital contributors. In commercial real estate, senior debt is usually a mortgage that is collateralized by the property and is often the largest layer of the stack. If a borrower defaults, the lender can take title to the property through a foreclosure and sell it to recover their investment, so there is reduced risk to investors’ principal. As such, expected returns are typically lower than for other layers of the cap stack.
- Mezzanine debt: As its name implies, mezzanine debt sits between mortgage secured senior debt and equity in the capital stack. Typically subordinate to senior debt but senior to all equity, mezzanine debt often fills a funding gap that can remain after senior debt and equity financing have been obtained. Generally, mezzanine debt is secured by the stock or the equity of the company that owns the property; it is not secured by the property itself. There is more risk involved in mezzanine debt than senior debt, so return expectations are usually higher.
Equity: Equity investing means becoming a shareholder in the ownership of the property. These are the riskier layers in the capital stack, as they are the last to be paid when things go wrong. At the same time, equity investments come with an entitlement to a share of the profits if the project performs well.
- Preferred equity: Preferred equity is subordinate to all debt but senior to common equity. Considered by many to be a hybrid between debt and equity, preferred equity can have qualities of both investment types. In general, preferred equity investments have payment priority, often called a “preferred return” over common equity investors and upon a default by the common equity. This often includes an ability for the preferred equity investor to cure a default and take control of the partnership and priority repayment relative to the common equity upon liquidation. Preferred equity may also entitle investors to some share of the upside when exiting the investment (like equity investments). This opportunity to share in the upside is often called an “equity kicker.” The risk and expected rate of return for preferred equity is generally higher than for mezzanine debt but less than the common equity.
- Common equity: Common equity investments are the primary beneficiaries of any possible gains, so they often appeal to those investors with a higher risk tolerance who are principally interested in achieving capital appreciation. (Debt investors, on the other hand, don’t gain from any asset appreciation.) In many commercial real estate transactions, the general partner is required by other investors to purchase common equity, known as having “skin in the game.” So long as the investment is “performing,” day to day controls and major decisions regarding the investment are made by the common equity investor. However, common equity holders have no guarantee to receive periodic payments or principal repayment, making this the riskiest layer of the cap stack; therefore, common equity has the highest potential return.
It’s important to choose real estate investments that fit within your risk tolerance and investment goals — and a close examination of the capital stack can help you make a smart, informed decision. The capital stack is particularly important to understand when it comes to illustrating what happens when an investment underperforms. As we’ve shown here, the cap stack reveals which investors’ claims have priority over others, how collateral is managed, and the level of protection your invested capital has. For investors focused on conservative deal selection, the capital stack offers a critical look into the relationship between different layers of the capital stack and helps to identify which tranche of capital provides the best risk adjusted return. At Cadre, we typically participate as a partner in the common equity of most investments, but also seek to opportunistically invest in mezzanine debt and preferred equity that optimize risk-adjusted returns to our investors.
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