Investors are most drawn to the real estate industry when it comes to investing. And for this reason, a sizable number of people today are investing in real estate. Although investing your hard-earned money is a fairly good idea, just like other investments, it also comes with associated risks.
So before investing in an attractive project, you not only need to understand the potential risk and rewards, but you also have to understand different investing structures. And one of the important concepts that you cannot neglect is the capital stack real estate. Knowing the capital stack can help you evaluate trade-offs and safeguard your investment against excessive risk or unsatisfactory profits.
What Is Capital Stack In Real Estate?
Several different sources of funding finance the majority of substantial real estate developments. So the amount of capital that is required for buying and running a commercial real estate venture is referred to as the capital stack. The stack specifies who and in what order will receive income and profits from the asset.
What Are The Layers Of Capital Stack?
There are four layers that an individual should know about in capital stack structure. These are broadly divided into two parts: Debt and Equity
Debt is divided into two parts: Senior debt and Mezzanine debt
Senior Debt
Priority is given to senior debt above all other capital stack levels. So, before any other investor receives a return on their investment, senior debt lenders must be paid. This is the least dangerous situation because the lender can seize control of the property through a foreclosure proceeding and sell the property to recoup the debt if the borrower doesn't make the mortgage payments.
Mezzanine Debt
Any remaining funds will be used to pay off the mezzanine loan after all operating costs and the senior debt amount have been met. It follows senior debt regarding payment priority and standing within the capital stack.
Equity is divided into two parts: Preferred Equity and Common Equity
Preferred Equity
Because preferred equity can have equity and debt investment elements, it is frequently viewed as a mixture of the two. Hard preferred equity positions work similarly to mezzanine financing, having a set rate and date of maturity. This type has a high payment priority called preferred return. Preferred equity often carries more risk and a lower projected rate of return than mezzanine debt but is still riskier than common equity.
Common Equity
The investment made by both the sponsor and the passive investors is common equity. This type is the riskiest as every other layer has to be paid before the common equity. But, when an investment is doing well, there is typically no cap on prospective returns; thus, with this risk comes the possibility of the highest profits.
Capital Stack Conclusion
Anyone thinking about investing in commercial real estate should thoroughly assess each option. Consider what the layers in the capital stack in real estate structure are. Check to verify if the sponsor's proposed business plan looks adequate for the balance of the financing sources. Be cautious when investing with a sponsor who uses a lot of debt and has a spotty track record of performance with properties profits. When the economy is struggling, highly leveraged agreements are frequently the first to face trouble, which puts the capital of common equity investors in danger.
