Understanding Capital Stack in Real Estate Investments
The capital stack describes the structure of investment capital in a real estate project and the level of risk investors take on with each tier in the stack. Before one can decide about investing in real estate opportunities, it is important to understand the concept and implications of capital stack in real estate investments and assess his/her risk tolerance against the potential investment. There are four levels of capital investment. Each has its own risk and reward profile for the investor.
How Is the Capital Stack Structured?
Imagine a layer cake or a stack of coins with four layers of varying thickness. The bottom layer is usually the largest, and it represents senior debt. Just above senior debt is the mezzanine debt layer, which is immediately under the preferred equity later. On the top of the stack is the highest layer, called common equity.
The above hierarchy is a simple visual that helps investors understand the capital structure of a commercial real estate project. At the bottom of the stack, you find the most security and typically, the least return on investment. At the top, you have the highest possible rates of return, but you run the most risk if the project does not go well. The two lower tiers represent debt while the two top tiers represent equity. Combined, debt and equity represent the entire investment in the property.
Senior Debt
Senior debt forms the base of the capital stack and is generally in the form of a first mortgage on the property and usually makes up about three-quarters of the entire project. This tier offers both the lowest risk and the lowest probable rate of return on a real estate investment. If you are especially risk-averse, this might be the right tier for your investment.
Senior debt has top priority if a project goes south and investors need to recover their funds. These investors are paid back first if something goes wrong. Debts are satisfied before equity in the case of default, and senior debt is satisfied before mezzanine debt.
For example, if you were to purchase a home and put down 25% of the value of the property as a down payment, the bank mortgage would equal the value of the difference, or 75%. If you defaulted on this mortgage, the bank would sell the property and recover the value of the bank loan before you would receive any portion of your 25% down payment.
Mortgage loans have very low rates because they are low-risk loans, secured by the property. This type of investment is relatively safe and dependable but will produce the lowest return.
Mezzanine Debt
The next layer up in the stack is also debt, but it is not typically secured by actual property. This debt can take the form of a second mortgage, home equity loan or line of credit. The person or bank who provides funds for the loan charges interest, which represents the return on this level of investment.
The interest rate is higher than the rate on the first mortgage because this is a slightly riskier loan. The rate of return is more favorable, but if the project does not go well, mezzanine investors only recover their investment after the senior debt holders. There is, in other words, a slightly higher risk that funds would be unrecoverable in the case of default but a higher rate of return commensurate with the higher risk.
Preferred Equity
Categories of equity on the capital stack are a little less clearly defined, but there are still two distinct tiers: preferred equity and common equity. Preferred equity varies from a combination of debt and equity, very close to a position of mezzanine debt, called “hard” preferred equity to a pure equity position (with no debt investments), referred to as “soft” preferred equity.
Preferred equity still generally has a fixed rate of return and a maturity date. This investment tier often comes with the right to take over management of the project if it fails or goes into default. All ranges of preferred equity carry a higher risk than pure debt positions but have somewhat lower risk than the topmost level of the stack.
Common Equity
The top tier is the riskiest investment but also offers the most lucrative possible returns if a project goes well. Common equity investors are to recover funds in case of default. On the upside, there is no limit to how much their investment can make on a successful project. This equity layer tops the capital stack.
What Other Factors Should Investors Understand?
All investments carry risk. Investors should always be aware of an investment’s level of risk and weigh it against potential returns. With fractional real estate investments, you can opt for debt or equity, and you might invest a small sum in multiple projects to diversify your real estate investments and hedge against a bad outcome on a single property.
As with any investment, it is essential that you do your research and understand the big picture. With real estate, obviously, the property itself matters. Investors should learn all they can about the history, location, condition, and prospects of an investment property.
Knowing who will manage the project is essential as well. If you opt for passive fractional investments and will not be repairing, maintaining, and renting out the property yourself, work with a reputable investment company so you know that the projects are being professionally managed.
Below are the other important factors that you should consider before making an investment:
Fractional Real Estate Investment
In fractional real estate investment, multiple investors pool their funds together to purchase a property, each with a proportional ownership stake. The Capital Stack determines the distribution of risk and returns among investors, making it a key factor in real estate diversification. Investors need to carefully consider the Capital Stack when evaluating fractional real estate investment opportunities.
Property Class
The type of property being invested in also has an impact on the Capital Stack. Different property classes, such as residential, commercial, and industrial, have different risk and return profiles and therefore require different types of funding. Understanding the property class and the associated Capital Stack is crucial in evaluating the potential returns and risks of a real estate investment.
Real Estate Diversification
Diversifying a real estate portfolio is important for reducing risk and maximizing returns. The Capital Stack provides a means for investors to diversify their real estate holdings by investing in different property classes and funding structures. This allows for a more balanced portfolio and can help to mitigate risk in the event of market fluctuations or economic downturns.
Investor Marketplace
Investor marketplaces, such as equity crowdfunding platforms, are changing the way real estate investments are made. By connecting investors with opportunities to invest in real estate, these platforms provide access to a wider range of investment opportunities and a more diverse Capital Stack. Equity crowdfunding also provides an alternative source of funding for real estate projects, potentially giving investors access to a new class of investment opportunities.
Why Is Understanding the Capital Stack Important?
The final piece of your investment decision is dependent on understanding your level of risk and choosing an investment structure with which you are comfortable. If you know where on the spectrum of risk you will invest your money, you will have a solid foundation for balancing your exposure against potential returns.
Some investors are only interested in a steady and protected position with a low but predictable rate of return. They would seek to invest at the base of the capital stack. Others are looking to maximize profits and will confidently accept more risk to pursue their financial goals. These investors are more likely to seek an equity position. Visit us at RealtySlices LLC to learn more about fractional real estate investing and diversify your portfolio to ensure that you get the best returns for the risk you take.
