The capital stack is one of the most important concepts for evaluating a real estate investment and its projected rate of return. Essentially, the capital stack represents the hierarchy of different sources of funding that contribute to financing a property project. Understanding which tranches of the capital stack carry the most risk, which are protected by senior debt, and how each position will receive cash flow throughout the hold period and upon sale can help investors evaluate tradeoffs and make appropriate investments.
Generally speaking, the higher a real estate investor’s position in the capital stack, the more risk they will take on and the lower their expected return will be. For example, common equity holders have the highest risk because they are actual owners of the asset and will lose their entire investment in the event that a deal fails. Conversely, preferred equity investors assume much less risk because they are not an owner and will only get paid after all of the other tranches in the capital stack have been repaid.
Debt is another important source of capital for a real estate project. Unlike equity, which involves ownership stakes, debt is borrowed funds that must be repaid over time along with interest. Using debt leverages a real estate project’s available resources and can allow developers to undertake larger projects that would otherwise be impossible with only equity as capital. Also read https://www.pandaprohomebuyers.com/can-you-sell-a-rental-property-with-tenants-in-maryland/
A capital stack is comprised of several tranches, including common equity, preferred equity, and mezzanine debt. In general, the most secure tranche in a capital stack is senior debt, which typically takes up the majority of the stack. Commonly known as a mortgage, senior debt has the advantage of being secured by the property itself and can be foreclosed on if payments are not made. However, because the stakes are so low in this tranche, senior debt offers the lowest expected returns.
The middle of the capital stack includes mezzanine debt, which is a hybrid between equity and debt. Like senior debt, mezzanine debt has security from the property as well as the ability to foreclose on the property in the event of default. It also has a higher risk profile because the investors in this tranche will only be paid after everyone else, but still offer a relatively high return for their level of risk.
The top of the capital stack is reserved for the actual property owner, which is also known as equity. Equity is the highest form of investment that can be made in a real estate project and will provide investors with the most potential upside if a deal is successful. However, the property owner bears the most risk in this position because they could be forced to sell the asset if it is not performing well. Fortunately, this is the least likely outcome and the risk is mitigated by the fact that equity investors will retain priority for receiving distributions from cash flow and capital transactions over other tranches in the capital stack.
