All real estate investment deals operate on certain principles. Every transaction differs from the other and carries a varying degree of risk, rate of return, repayment options, etc. However, the primary component of all deals is capital, without which no investment is possible.
The two most important sources of capital are debt and equity. Most transactions involve a combination of these sources because funding from an exclusively single one is almost impossible.
Areal estate capital stack best illustrates the capital layers required to buy a property. It also shows their risk and returns on investment potential and their position compared to each other within the chart.
If you have yet to learn about capital stack, this article will provide you with essential information, including its various parts, importance, and the repayment priority enjoyed by each layer.
How does the stack work?
The stack representing the various capital sources consists of four layers, divided between equity and debt.
Buying a property requires a significant amount of capital, requiring the investor to borrow money from a debt lender, which is usually the bank or bondholder. These are senior and mezzanine debt lenders.
These occupy the lowest position in the capital stack diagram and are called seniors because of their higher position than other layers.
Besides being the largest investors in a property deal, they face the lowest degree of risk because they offer a loan against collateral and receive the highest priority for repayment. If borrowers default on a loan, they can reclaim the money by seizing real estate assets like homes or vehicles.
They occupy a lower position compared to senior creditors. Mezzanine lenders usually receive their payments after successfully paying senior lenders and operating expenses.
Compared to senior creditors, mezzanines enjoy a higher rate of return but an increased risk. The high risk stems from the absence of security, except perhaps a junior lien on a property or pleading of shares.
However, they cannot become a part of a deal unless approved by the senior lenders. Most investors prefer paying this capital source early because of its higher interest rate, which increases with time.
Companies that buy properties usually raise equity to bridge the gap between the senior debt and purchase price, which they offer to limited partners or passive investors.
Equity investors enjoy the highest position in the capital stack. Because they take the highest risk on their investments, the rate of return is very high for them. They fall under two categories: common and preferred.
Common equity is raised by property owners/managers and equity investors. The potential for the rate of return is the highest for them because of an absence of ceilings.
In most cases, they receive payment from debt holders and preferred equity investors. Even though they don’t receive a guarantee of cash flow, companies provide a cash flow on a quarterly or monthly basis.
Preferred equity combines the characteristics of debt and equity and has similarities to mezzanine debt, as investors receive their payment monthly or quarterly.
In most cases, preferred equity investors generally receive the cash flow before common investors according to the previously agreed upon preferred return amount.
Before entering into commercial real estate, you should consider thereal estate capital stack carefully and the position occupied by every lender or investor in the stack. Understanding the risks and expected rate of return ensures you receive the maximum returns.