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. There are many ways to invest in real estate including by owning rental properties, buying properties to rehab or develop for resale, investing with other persons who buy or develop property, investing in a real estate investment fund or real estate investment trust which aims to diversify risk by pooling your investment with others to make numerous real estate investments and generate a stable return, or investing in individual trust deeds where you essentially act as the lender to a third party real estate developer, to name a few.
Before one selects the proper real estate investment for his/her particular needs, it is essential that he/she identifies the risk associated with the investment in question. One important term you will often here which relates to the risk assessment is the “capital stack.” When it comes to real estate investments, the capital stack refers to the various layers of funding that are required to finance a real estate investment.
Where your investment falls within the capital stack and the priority it has in relation to other positions in the capital stack directly bears on the risk of the investment in question. If everything goes according to plan, all positions in the capital stack will be paid the targeted return. Unfortunately, however, things don’t always go as planned, and you want to make sure you understand your position in the capital stack so that you can make an informed decision before you decide to invest. By identifying where your investment is situated within the capital stack, you will be able to understand more about when you get paid and the amount of underlying risk associated with the investment.
Though the capital stack will likely be structured differently based on the particular investment, the most common four layers of the capital stack in real estate investments are common equity, preferred equity, mezzanine debt, and senior debt. Some capital stack structures have fewer layers, such as, just debt and equity, and others have more.
The capital stack generally tells you the order of priority of payout with respect to other positions within the capital stack. Starting at the bottom of the capital stack, the senior debt will be paid out first, then the mezzanine debt, then the preferred equity and finally the common equity. If the real estate investment doesn’t perform as projected, there may not be enough money to repay all money invested along with returns. The bottom layers will be repaid first, and the top layers will incur losses before anyone else.
Thus, your position in the capital stack directly relates to your risk. If you happen to be towards the top of a capital stack, you will inherently have more risk than the lower layers. If you are in the bottom of the capital stack, your investment will be safer relative to the other positions in the capital stack.
The projected return, however, is generally structured to correspond to the amount of risk. While investing in the bottom of the capital stack is typically more secure, it also typically generates lower returns. While investing in the top of the capital stack is less secure, there tends to be more upside potential. Keep in mind you can also vary your risk and returns by investing in multiple layers of the capital stack at the same time depending on your investment goals.
The specific terms and structure of any particular investment will certainly involve many more complexities, but having a basic understanding of the capital stack can provide a solid foundation to build from. This article endeavors to provide you that foundation.
As touched on above, the four most common components of a real estate capital stack include common equity, preferred equity, mezzanine debt, and senior debt. We’ll start our discussion from the top and work our way down.
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.
It is risky for numerous reasons. First, 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. In other words, you’ll get paid last. Second, the common equity layer typically does not have a recorded secured interest in the property, nor is it typically entitled to reoccurring payments. Rather, the return of the entire investment, principal and potential returns, typically will not be realized until the property is sold or there is another liquidity event. If the investment does not perform as projected, you are potentially at risk of losing some or all of your initial investment.
On the other hand, investing in the common equity layer of the capital stack can be the most lucrative. Potential returns typically aren’t capped for common equity investors. Thus, in the event that the investment is largely successful, common equity investors could realize very sizable returns.
If you are investing in the common equity layer, you will typically be standing side by side with the sponsors of the real estate investment. The sponsors are often relegated to the highest position in the capital stack. This incentivizes the sponsor to maximize the returns for every position in the capital stack, because the sponsor will only realize its returns if every position below is first paid. Once everyone below is paid, the sponsor, along with other investors in the common equity layer, also capture any remaining upside.
The preferred equity for a real estate investment is the layer of a capital stack that falls just below the common equity layer. It is a malleable layer that comes with a significant amount of flexibility in regards to how it is structured, but typically entails a preferred rate of return that must be paid, and therefore provides more certainty than the common equity layer. The preferred equity layer will also have the right to repayment before the common equity investors, which lowers the amount of associated risk.
The preferred equity layer is commonly structured as a hybrid to share characteristics of the common equity and mezzanine debt layers. Like the common equity layer, the preferred equity layer will typically share in some (though less) of the upside of the investment. Like the mezzanine debt layer, the common equity layer may also have a right to regular recurring payments.
While there are many potential ways to structure the preferred equity layer, investments in this layer are often differentiated as either “hard” or “soft.” A “hard” preferred equity investment tends to be less risky. It typically requires that the preferred return must be paid regardless of cashflow or the performance of the investment, and involves varying remedies if payments are not made, including the right to take control of the investment or force its sale. In this way, it operates much like the mezzanine debt layer described next.
In contrast, a “soft” preferred equity investment typically only requires payments if there is sufficient cash-flow, and may or may not entail remedies if those payments are not made. In this way, a “soft” preferred equity investment is more similar to the common equity layer.
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, and before the equity layers. Mezzanine debt typically involves characteristics of senior debt and equity. Like senior debt, mezzanine debt investors will typically have a right to receive regular payments at a stated rate not tied to the performance of the investment, and that rate will typically be higher than the senior debt rate because of the increased risk. Like equity, mezzanine debt investors will typically have a right to share in a portion of the potential profits, but a much lower portion than the equity layers.
Unlike senior debt, however, mezzanine debt is not typically secured by a recorded interest in the property itself. While mezzanine debt investors may have limited foreclosure rights, those are typically governed by the terms of agreements among the parties. Unlike equity, mezzanine debt is debt. The right to repayment attaches regardless of the performance of the investment.
The mezzanine debt layer can be attractive if you want to share in some of the potential upside, while also securing a guaranteed right to payment at a lower position in the capital stack.
Senior debt for real estate investment is the very foundation of the capital stack. It is typically the largest, least risky, and least expensive portion of the capital stack. As an investor, if you want your investment to come with the least amount of risk attached to it, you should consider a senior debt investment.
Senior debt is secured by a deed of trust or a mortgage recorded against the property, which means that you will be able to claim the title of the property in the event that the borrower defaults on making its regular payments through the foreclosure process. It is also structured to require regular monthly interest payments at a stated rate, that is not tied to the ultimate performance or success of the investment.
Because of its lower relative risk, returns for senior debt investments are also lower. As a senior debt investor, you will not have the right to share in any of the potential upside or profits of the venture. Whatever rate is negotiated and stated in the loan documents, is the return that you can expect to receive.
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 one’s broader portfolio strategy and risk appetite. 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. If, on the other hand, one wants a risk-averse investment with a lower rate of return, it’s much better to be positioned at the senior debt or mezzanine debt layers of the capital stack. One can 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.
Understanding the capital stack is, however, only one small, albeit important, piece of information necessary to assess the risk and evaluate if a real estate investment is right for you. For example, you can invest in the senior debt portion of the capital stack, but if the underlying investment is not otherwise sound, it still could be a bad investment. Conversely, a common equity investment could be well worth the associated risk if other factors exist to mitigate the risk and provide the opportunity for significant upside.
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