A common saying exists in commercial real estate: financing is king. In other words, before considering a project, consider how you can pay for that project. Without a clearly defined and executable financing plan – known as a capital stack – a great deal remains nothing more than an idea. To properly analyze deals, new investors should first familiarize themselves with different options available. As such, we’ll use this article to provide an overview of commercial real estate financing and the capital stack.
Specifically, we’ll discuss the following topics:
- Commercial Real Estate Capital Stack Overview
- Financing Categories of the Capital Stack
- Final Thoughts
Commercial Real Estate Capital Stack Overview
In commercial real estate, the capital stack refers to the different financing layers used to fund a given deal. To understand this concept, it helps to think of purchasing a home. Say a bank will provide you an 80% loan-to-value (LTV) mortgage to purchase a $500,000 home. That LTV translates into a $400,000 mortgage, meaning you’d need to contribute $100,000 of your own money as a down payment.
In this basic example, your $100,000 in contributed capital would sit on the top of the capital stack, and the $400,000 mortgage would sit on the bottom. This positioning on the capital stack relates directly to seniority, risk, and returns. The lower on the capital stack, the more senior the financing source. In this case, that means that, if you sold your home, before taking any cash from the deal, you would need to pay the outstanding mortgage.
This system means that the higher on the capital stack, the riskier the financing source. For instance, if the value of your home decreased when you sold it, you may not recoup your initial $100,000 in capital – or any capital at all. To compensate for this risk, the higher on the capital stack, the larger your upside potential.
To demonstrate this upside potential, assume after several years, your home value increases to $1,000,000. When you sell the property, the lender doesn’t receive any more cash than the outstanding loan balance and associated interest and fees. However, as the equity holder in a riskier position on the capital stack, you recoup your initial investment plus a large return based on the increased value.
Financing Categories of the Capital Stack
Generally speaking, five different categories of financing exist in a commercial real estate capital stack. Not every deal will have each, but investors should have a working understanding of these categories. In the following, we have listed the capital stack categories from least senior (common equity) to most senior (senior debt):
At the top of the capital stack, common equity typically includes the funds contributed by a deal’s sponsor, or general partner (GP). As the least senior financing category, common equity holders receive cash last in the sale or refinance of a property. But, they typically also have a higher rate of return based on solid deal performance, compensating them for this increased risk.
Next down the capital stack, you see preferred equity. This generally includes the capital contribution made by a deal’s equity investors, or limited partners. These investors are more junior than debt financing but senior to the common equity. As such, they typically receive a preferred – or required – return on their capital. And, in a successfully executed deal, they’ll receive a share of the deal’s upside as equity holders – albeit at a lower rate than the common equity holders.
Mezzanine financing often acts as a sort of hybrid financing, with elements of both debt and equity. If a deal requires funds to bridge the gap between the debt and equity financing components, the sponsor may secure mezzanine financing to make the deal happen. This usually begins as a debt instrument with an option to either A) buy out, or B) convert to equity. However, unlike junior and senior debt, mezzanine lenders normally do not have a recorded lien on the underlying property.
Deal sponsors usually secure mezzanine financing from private lenders.
Junior debt represents the second most senior financing category in the capital stack. Frequently, this category includes second mortgages and other construction- or renovation-type loans secured in addition to a first mortgage. Accordingly, junior debt holds the second-position lien on a property. Due to this second position, junior debt commands higher interest rates than senior debt, and it also normally has shorter terms.
For instance, several years after purchasing an apartment building, you take out a second mortgage to renovate some of the units. This loan would likely be interest-only with a one- to three-year term. In the event of a bankruptcy during the renovation period, this loan would be repaid after the senior debt but before any outstanding mezzanine financing or equity.
Senior debt sits at the bottom of the capital stack. As a result, this financing source takes priority over everything above it. That is, with senior debt, the lender holds the first-position lien on the underlying property. In the event of a property sale (or foreclosure), cash proceeds would go towards paying off this senior debt before anything else. However, this means that senior debt financing receives no upside potential from a deal. Lenders just recoup outstanding principal, interest, and fees in accordance with the loan terms.
In most situations, a deal’s permanent mortgage holds the senior debt position. These loans are amortizing and longer term than most junior debt. In smaller commercial deals, banks or credit unions often provide these loans. Larger deals, on the other hand, may require life insurance companies or Wall Street to provide these funds.
While we covered all the financing categories of a capital stack in this article, we barely scratched the surface when it comes to the different financing sources available within each of those categories. But, as a new commercial real estate investor, understanding how a capital stack works will arm you with the knowledge to analyze the financing risks and rewards of a potential deal. Having a grasp of these categories – and the overall capital stack structure – also allows you to seek out different financing sources for individual deals.
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