The Real Estate Capital Stack and How it Works
If you’re looking to invest and set yourself up for long term financial success, one type of investment that you may want to consider is investing in real estate. These investments focus primarily on growing your financial wealth through equity investments in property or land.
Four primary ways investors grow their wealth through real estate investing includes (to name a few) renting out an owned property collecting rent from current tenants, purchasing and flipping (selling) a home quickly for a profit, participating in a real estate investment trust, or being a part of a real estate investment fund which aims to generate a preferred rate of return on your investment.
Before one seeks out a real estate investment, it’s essential they identify the risk that comes with any investment in question, which can be better defined by looking at their position in the “capital stack”. When it comes to real estate investments, the capital stack refers to the various layers of financing that are required when funding the initial purchase and eventual improvement of the property. If everything goes according to plan, the investment will reach all of its future targets, which means that everyone who invested would realize their targeted return.
However, there is always going to be an inherent risk that comes with making such investments. By identifying where your investment is situated within the capital stack, one will be able to understand more about when they get paid and the amount of underlying risk associated with the investment.
Even though there can be many layers of a capital stack, the primary four layers that one should be aware of include common equity, preferred equity, mezzanine debt, and senior debt. The capital stack tells you the order of repayment after sale or refinance of the property. If there are not enough funds to repay everyone, the top layers will incur losses before anyone else. If you happen to be towards the top of a capital stack, you will inherently have more risk than lower layers.
The upside to being at the top of the capital stack is that any gains from the initial investment will be provided to the top of the capital stack and often come with greater returns . The capital stack can be a very complex investment structure, in the following article, we will explain the layers and benefits of each position in the real estate capital stack.
Common Components of the Capital Stack
When you’re getting ready to engage in real estate investing, there are four primary layers of a capital stack that your investment may be positioned in. Keep in mind that it’s possible to invest in two or more of these stacks at the same time depending on what your goals are with your investment. The four main components of a real estate capital stack include common equity, preferred equity, mezzanine debt, and senior debt.
The common equity of an investment is considered to be the top layer of a capital stack. This portion of a real estate stack is considered to be the riskiest yet potentially most rewarding layer.
When you’re involved in this layer of the investment, every other layer of capital that was invested into the project will receive repayment before you do. On the other hand, common equity investors often won’t have a cap on potential returns in the event that the investment is successful, which is why this layer of a capital stack can provide the best returns. While all investors will be able to receive a return on the investment, a much higher percentage of remaining profits will then be provided to the equity investors.
Keep in mind that equity investments can differ somewhat in regards to the risk/return percentage. It’s possible for a high preferred return to be placed into the investment agreement, which can lessen the risk. It’s also important to understand that larger and more competitive real estate markets like San Francisco and New York City will come with some protection against risk. However, this lowered risk means that the potential rewards will be lower as well.
The preferred equity for a real estate investment is the layer of a capital stack that’s just below common equity. This is a very malleable layer of investment that comes with a significant amount of flexibility in regards to potential risk/reward. With preferred equity, you will have the right to repayment before common equity investors, which slightly lowers the amount of risk that comes with this investment. It’s often possible for one to make a “hard” preferred equity investment, which is the least riskiest type of preferred equity investment that one can make. The returns that one receives with this investment will be a fixed percentage.
A “soft” type of preferred equity investment is one that may be able to provide better returns in the event that the project goes well and the investment pays off. However, there are some additional differences with hard and soft preferred equity investments that one should be aware of.
When one makes a soft preferred equity investment, their rights will be more restricted in regards to making decisions. If one wants a flat yet high annual return for their investment, this may be the type of real estate investment for them. This is often times considered to be a great form of investment for real estate investors who want significant returns without the high risk that comes with a common equity investment.
The mezzanine debt layer sits just above senior debt in the capital stack, which means that payment priority will come immediately after any senior debt investors. If the developer of the project has repaid the senior debt investors but doesn’t have enough money to repay you in accordance to the agreement that you made, you may be able to take control of the property in question. In most cases, any mezzanine debt investors will make an agreement with senior debt investors on what happens in the event that the developer doesn’t pay either of them.
When getting involved in a mezzanine debt investment, you will have a higher potential ROI when compared to senior debt investors. While your rights are limited when compared to the rights a senior debt investor has, you have some foreclosure rights based on the agreement that you’ve made with senior debt investors. If you want to receive at least some of the additional profits from a successful real estate investment, this a type of investment to engage in that will allow you to garner less risk.
The senior debt for real estate investment is the very foundation of a capital stack. If you want your investment to come with the least amount of risk attached to it, you should consider a senior debt investment. This type of investment is secured directly by a deed of trust or a mortgage, which means that you will be able to claim the title of the property in the event that the borrower doesn’t perform on making his or her’s payments.
The risk is minimized with this form of investment since you effectively own the property in the case of default, which means that you can choose to sell the property or the non-performing loan to recover the money that you put into the investment. While senior debt investors have lower risk associated with their investment, they will also have a lower yield on the amount of money that was invested. To determine how much risk is involved, it’s essential that you assess the loan-to-value (LTV) of the loan.
In real estate investing, a lower LTV ratio is preferred over a higher ratio. If someone puts $400,000 down on a property worth $1,000,000, the LTV ratio would be 60 percent, which means that the loan amount would be 60 percent of the value of the home. If the borrower stops paying and you decide to sell the property to recover your investment, you have a 40 percent equity cushion if the property didn’t decrease in value. A higher LTV ratio of 85-90 percent would be much riskier for you as an investor. Regardless of the LTV ratio, you’ll always be paid first upon the sale of the property, which makes this a lower-risk investment than the other options noted above.
What Your Position in the Capital Stack Means for You
It’s important to understand that different positions in the capital stack will affect the investment in different ways. The position that one should take in a real estate investment all depends on what the broader strategy of their portfolio is. If the intent is to make risky investments that could provide the highest ROI, the focus is usually on the common equity and preferred equity layers of the capital stack in a real estate investment. If, on the other hand, one wants their portfolio to be risk-averse, it’s much better to be positioned at the senior debt or mezzanine debt layers of a capital stack.
While debt investments often times come with lower returns, you’ll also be among the first to be paid back if the property is sold or refinanced at a loss, which greatly reduces the level of inherent risk with the investment. One could also consider being in different positions of the capital stack at the same time, which helps to spread out risk and obtain higher blended returns. Since one can invest in different positions, one can assume the risk/reward ratio they believe would be most beneficial to their overall investment portfolio.
If you have any questions about the real estate investment process or would like to learn more about available real estate investment opportunities in California, contact us today and we’ll be happy to discuss your real estate investing goals!