When you’re searching for ways to invest in real estate, likely one of the most important terms related to the investment is the capital stack, which refers to the various types of capital that are invested into a real estate investment project. When looking specifically at a commercial real estate project, the types of investments that make up a capital stack include senior debt, mezzanine debt, preferred equity, and common equity.

While some real estate investors will focus solely on one type of investment, it’s also possible to spread your investment across different sections of the capital stack, which will help you diversify your portfolio. While the common equity and preferred equity layers of a capital stack come with more risk, they can also provide you with higher returns. Despite the lower returns of mezzanine debt and senior debt, making investments in one of these layers allows you to acquire much less risk. If you want to maximize your returns while making sure that the risk doesn’t spiral, having a well-structured capital stack can affect how well your portfolio is diversified, various tax considerations, and the amount of risk that you take on.

stacked books

For an investment that you make on a real estate project to be worthwhile, it’s important that the return you obtain is higher than the amount you invested. If you’re the main equity holder of a property and are in charge of its development, having an optimal capital stack can be highly important if you want to minimize your losses. If all of your investments go into the riskier common equity layer of a capital stack, your portfolio won’t be very diversified. You also risk losing much more than you make if the project doesn’t pan out. An optimal capital stack is one that has the right mix of debt and equity to it. The following will provide you with seven considerations to consider for an optimal capital stack.

1. Your Business Risk

chess game risk

One of the top considerations that you should take into account is the business risk that’s associated with your investments. If the type of property that you’re investing in comes with lower risk and steady cash flows, you’ll likely want the capital stack structure to have a higher amount of debt in it. If your investments mainly include mezzanine debt and senior debt, your returns should be consistent. If the property happens to fail and payments aren’t met, any senior debt holder will have the ability to foreclose and take ownership of the property in question, which helps to minimize risk. Apartment buildings and commercial properties that are credit-tenant leased are considered to be examples of low-risk properties with steady cash flows.

If the property that you’re investing in is an office building that’s located in a highly competitive market, you should expect that the building will have an extensive amount of turnover. With this type of property, it’s highly recommended that the capital stack structure of the building is focused more on equity than debt, the latter of which is borrowed money that must be paid back to the lender.

Businesses with a high amount of equity will have ownership rights for the property itself, which means that the equity portion of the investment won’t need to be paid back. For properties that have a higher chance of failing and not bringing in the right amount of returns, more equity can be preferable compared to a higher amount of debt.

If you analyze the risk of your investment, you’ll be able to more accurately determine what your optimal capital stack should be. When you’re thinking about funding a new project, understanding the capital stack structure of the property in question will allow you to keep your risk profile at the appropriate levels.

2. Interest Rates

calculator calculations money

It’s also important that you take the interest rates into account for the different levels of a capital stack structure. Debt is going to be less expensive than equity. If the owner of the property doesn’t provide you with consistent payments, you will be able to sell the property in order to recover some of your investment. When you hold equity on a property, you will have a claim on any remaining assets of the property. However, all other obligations to debt holders will need to be satisfied beforehand.

This is where the interest rates of a capital stack come into play. The interest rate or return rate for a senior lender will be around 4-8 percent per year, which is a relatively low rate. While the interest rate that you receive is low, you also have less risk and more security with your investment. As for a mezzanine lender, interest rates are typically around 9-13 percent, which allows for a much higher return. Interest rates for preferred equity investments can be upwards of 18-20 percent, which allows for a significant return on investment.

When considering the common equity layer of a capital stack, you can expect returns to be as high as 25 percent. Even though preferred equity and common equity investments can provide you with high returns, the business risk is also much higher. In the event that the real estate project fails, every other type of investor will be paid back before you. The interest rate and return rate that’s best for you all depends on the level of risk that you want to take on. You could also invest in several layers of the capital stack to ensure that you receive consistent returns with senior debt and potentially high interest rates with common equity.

3. Understanding the Credibility of the Assets

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In order to be certain that you’ve made the right investment with a real estate property, it’s essential that you understand the credibility of all of the assets that are placed in the property. While it’s easier to determine the credibility of assets for the capital structure of a business because of the extensive balance sheet they have, you should be able to identify the credibility of real estate assets without too much difficulty. Whether you’re investing in commercial real estate or infrastructure, the credibility of the assets depends on the credibility of the property. If your investment is going into a biofuels energy project, you can be fairly certain that the asset is a riskier one when compared to a standard real estate investment.

No matter your position in the capital stack structure, determining the credibility of the asset is key to understanding if you’re making a wise investment choice. If the quality of the property or asset that you’ve invested in becomes impaired, it’s possible to lose your entire investment, which is true whether you’re a senior debt holder or an equity holder. To determine the credibility of an asset, it’s recommended that you perform regular valuations.

4. Bankruptcy

petition to file for bankruptcy paperwork

It’s possible for you to declare bankruptcy if you are unable to repay creditors. When this occurs, the debt could be discharged or restructured. As an investor in real estate, it’s important that you understand what happens in the event of a bankruptcy. There are two main types of bankruptcy that you should be aware of, which include Chapter 7 and Chapter 11 bankruptcy. With Chapter 7 bankruptcy, the property that you’ve invested in will be liquidated, which means that any mortgage holders or senior lenders will be paid back before any remaining money is provided to equity holders. With this type of bankruptcy, there is typically very little capital left over for holders of common equity.

If you currently own the building because of the amount of equity that you’ve invested into the property, filing a bankruptcy can cause you to lose the property and the money that you’ve invested into it. Chapter 11 bankruptcy focuses on the restructuring of debts, which allows lenders to be paid back over a lengthy period of time. The best way to minimize the possibility of bankruptcy and potentially prevent it from occurring is by heavily cutting your expenses, using debt management services, and attempting to negotiate with your creditors.

5. Trade-Off

balance rocks

The trade-off consideration is one that determines how much debt and equity are placed into a building by the benefits and costs that come with both. When debt increases in a building, the benefits become lower while the costs increase. Even though equity starts out as being more expensive because of a lack of tax savings, higher amounts of equity will lessen in risk over time compared to high amounts of debt.

6. Financial Flexibility

stacks of money

If you own a property that has a mortgage on it, you need to consider the financial flexibility of the capital stack structure. Loan payments will need to be made every month. If you can’t make these payments or pay off the loan in full once it reaches maturity, you will risk the need to file bankruptcy or even lose the asset altogether. If the economic signs in the area for the property that you’ve invested in are currently mixed or even negative, you should consider a lower debt-to-equity ratio. Lower debt means that you’ll have more flexibility during tough moments in the economy.

7. Lender Appetite

business people

Lenders don’t always have a strong and aggressive appetite for making loans with a real estate property. If the surrounding market is currently going through difficult times, lenders will usually be less interested in providing loans for a property. The key to discerning how much debt you’ll use for your real estate investment is to first identify how willing lenders are to provide you with a loan.

When lenders and investors are highly aggressive, you may be able to obtain the money that’s needed for a riskier project. However, this can be a problem at times. When lenders are aggressive and agree to provide you with a loan for the property, they might require much higher returns and even control of the project, which you should consider when investing. It’s recommended that you maintain a healthy balance of equity and debt.

Building an Optimal Capital Stack Structure

You want to focus on building an optimal capital stack structure with your real estate investments if you want to have the right combination of risk and steady returns. While each individual investor has a different capital stack structure that’s right for them, it’s recommended that you avoid becoming too focused on just one layer of the capital stack. If all of your investments are common or preferred equity investments, the risk of losing everything that you’ve invested is greater. If the majority of your investments go into senior debt, your returns will most likely be lower. A healthy mixture of the two gives you a chance to obtain high returns while also lessening the amount of risk that you take on.

You should take all of the previous considerations into account because of the general risks that come with making any kind of investment. Real estate investing is never easy. However, you can mitigate the risks by better understanding what goes into a capital stack structure. For instance, if the asset that you invest in turns out to be worthless, it won’t matter that you’ve made a low-risk senior debt investment. You’ll still lose most or all of the money that you’ve invested. Making smart investments in real estate means understanding everything that goes into the capital stack structure of a property.

*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.