002: Real Estate Capital Stack

VestCapital Podcast

In real estate, the capital stack refers to the hierarchy of financial layers or types of capital that are used to finance a property investment. Each layer in the capital stack has a different level of risk and return, with the order of the layers representing the priority of payment.

Here’s a breakdown of the main components of the capital stack:

1. Senior Debt:

   • Position in Stack: Bottom layer
   • Description: This is usually the primary loan or mortgage financing provided by a commercial bank or other traditional lender. It has the lowest risk because it's secured by the property itself, meaning the lender can take possession of the property if the borrower defaults.
   • Return: Typically the lowest return (interest rate) due to the lower risk.
   • Payment Priority: First in line to be paid.

2. Mezzanine Debt:

   • Position in Stack: Above senior debt, but below equity.
   • Description: This is a secondary layer of debt that carries more risk than senior debt but less than equity. Mezzanine lenders do not have a claim on the property itself but may have rights to the borrower’s equity in the property if there is a default. This type of debt is often used when the senior lender restricts the amount of senior debt.
   • Return: Higher interest rates than senior debt due to increased risk.
   • Payment Priority: Paid after senior debt but before equity.

3. Preferred Equity:

   • Position in Stack: Above mezzanine debt, but below common equity.
   • Description: Preferred equity investors are equity holders with a preferred position over common equity holders. They receive returns after all debt obligations are satisfied but are typically promised a minimum return before common equity holders are paid.
   • Return: Higher than mezzanine debt, often fixed, with less risk compared to common equity.
   • Payment Priority: After all debt, before common equity.

4. Common Equity:

   • Position in Stack: Top layer.
   • Description: Held by the sponsor of the real estate deal and potentially other equity investors, common equity holders take on the most risk since they are the last to be paid. However, they also have the highest potential upside if the investment performs well, as they are entitled to all remaining profits after everyone else in the capital stack has been paid.
   • Return: Potentially the highest, but with the most risk.
   • Payment Priority: Last in line to be paid.

The capital stack structure is important for understanding the risk and return profile of an investment and how different investors or lenders are positioned in terms of priority for repayment.