In almost every significant property transaction, finance is obtained using a combination of equity and debt rather than cash. This finance is provided by investors, who require a return on investment as a reward for risk-taking. Different levels of risk attract different returns, and a “capital stack” is created. What a capital stack is and why understanding it is so important is what this article is all about.
The capital stack refers to the layers of financing used to fund a real estate project. Typically made up of four layers, each representing a form of capital with varying levels of risk and return, the stack is something investors considering participating in a syndicate need to understand.
For anyone wanting to invest in property through a syndicate, it is vitally important to do a thorough analysis of the capital stack associated with the financing of the transaction. This analysis will allow the potential investor to identify and quantify the risk and balance that risk against the returns that are being offered. In this article, I’ll take you through how to protect your property investment.
Understanding the Capital Stack Before Investing
The “capital stack” is, by definition, the structure of capital used in financing the purchase of a commercial property. The stack can comprise up to four layers:
1. Senior Debt
Senior debt is considered the lowest risk level. It earns the lowest return but holds the highest priority for repayment in the event of default or liquidation. It is typically provided by traditional lending institutions such as banks or institutional investors. Senior debt is secured by the property itself and has a first lien position, meaning that in case of foreclosure or sale, the proceeds will first be used to repay the senior debt before any other debt holders are satisfied.
2. Mezzanine Debt
Mezzanine debt lies between senior debt and preferred equity in the capital stack. It is considered a hybrid form of financing since it possesses characteristics of both debt and equity. Mezzanine debt providers typically consist of specialized lenders or private equity firms. This type of debt is unsecured, meaning it lacks collateral directly tied to the property. Instead, it relies on the equity value and cash flow generated by the property.
3. Preferred Equity
Preferred equity refers to an ownership interest that has certain preferential rights and privileges over common equity. It typically offers a fixed return but ranks below senior debt in the capital stack. Whereas senior and mezzanine debt usually derives from the following:
- Financial institutions
- Hedge funds
- Private individuals
Preferred equity holders have priority in receiving distributions and are entitled to a predetermined dividend.
The risk associated with preferred equity is lower compared to common equity since preferred equity holders have a higher claim on the property’s cash flow and proceeds in case of liquidation. However, the returns are generally lower than those of common equity because of the reduced risk profile.
4. Common Equity
Common equity represents the residual ownership interest in a property or project after all other obligations have been satisfied. Common equity holders bear the highest risk in the capital stack but also have the potential for the highest returns. Their returns are not fixed and depend on the property’s performance and appreciation.
Common equity holders have the last claim on the property’s cash flow and proceeds, making them more exposed to market fluctuations and downside risk. However, they also benefit from the property’s upside potential, such as increased rents or property value appreciation.
If all goes well with the property, everyone in the capital stack gets paid. However, repayment priority becomes critical when things don’t go according to plan, and it could be the difference between an investor getting paid most of their money back versus losing it all.
Investors must evaluate where their money is positioned in the capital stack in terms of the rights and repayment priorities that come with it before finalizing their investment.
Investing In Property Through A Syndicate
Now that we’ve defined the various levels that make up a capital stack, it’s important to know where in the stack the syndicate’s investment falls if you’re investing as part of a syndicate.
Risk assessment: The capital stack provides insights into the risk profile of property investment. By understanding the different layers of financing, investors can evaluate the priority of repayment in case of a default or liquidation. The higher a layer is in the capital stack, the more senior its position is, which typically means a lower level of risk.
Return expectations: Typically, the higher-risk layers of the capital stack, such as equity or mezzanine financing, provide potentially higher returns, while lower-risk layers, such as senior debt, offer more modest but safer returns. Understanding where a syndicate’s investment falls within the capital stack can help investors set realistic return expectations.
Payment priority: The capital stack determines the order in which different capital providers receive payments. Senior debt holders, being at the top of the stack, are the first to be repaid in case of a liquidation.
Equity holders, on the other hand, are at the bottom of the stack and receive their returns after other capital providers. Understanding the payment priority helps investors assess their potential risk and the likelihood of receiving a return on their investment.
Debt coverage: Analyzing the capital stack allows investors to assess the level of debt on a property. Higher levels of debt increase the risk of a project during challenging market conditions. By understanding the proportion of debt in the capital stack, investors can evaluate the project’s financial stability and the potential impact on their investment.
Alignment of interests: The capital stack also reveals the alignment of interests among the different participants. Equity investors, who have the most at stake, are often more motivated to actively manage and improve the property’s performance.
Debt investors have more limited upside potential and focus on protecting their capital. Understanding these dynamics helps investors gauge the commitment and motivation of the syndicate’s sponsors or managers.
Understanding the capital stack in a property investment opportunity allows investors to assess the risk-return profile, payment priority, debt coverage, and alignment of interests. This knowledge is crucial for making informed investment decisions before investing in property with a syndicate and in the creation of a well-balanced property portfolio.