Capital Stack in Private Commercial Real Estate Investing
Capital stack is the hierarchy of the sources of capital financing a real estate investment or development project.
Each source of funding has a
unique risk vs return profile. And generally, the higher the risk, the higher the return on investment (ROI). Investors must understand the different sources of capital and risks associated with each one. The investor’s position in the capital stack determines when they get a return on their investment, and return of capital. Return on investment and return of capital is determined by an investor’s position in the capital stack. There are different legal and financial requirements for each position within a capital stack. For example, if an asset underperforms and loses money, the loan still has to be paid back. Therefore, senior debt holders receive payment first. The two most common types of sources for capital are divided into Debt and Equity. These categories have further sub categories that play into the final capital stack.
Different Types of Debt
1. Senior Debt
Senior Debt usually involves debt received from a financial institution such as a bank or private lending company to fund the acquisition or development of the property. Senior debt is at the bottom of the capital stack because it has the least amount of risk. The underlying asset is collateral for the loan issued. This prevents the asset from being sold or refinanced until the senior debt holder has been paid back with interest. This includes any other legal requirements as determined by the mortgage. While it is the safest position in the capital stack, it also receives the lowest return. Cash flow to senior debt holders is tied to fixed or variable interest rates.
2. Mezzanine Debt
Mezzanine Debt comes second to senior debt in payment priority. Mezzanine debt holders receive a higher interest rate payment compared to senior debt holders. These debt holders are paid after senior debt holders' obligations have been completely paid off. Mezzanine debt holders receive a higher return than senior debt holders because this position in the capital stack is comparatively riskier. However, mezzanine debt holders receive a lower return compared to equity investors because mezzanine debt holders have a junior mortgage and a pledge of equity with the borrower. In many cases, senior debt holders or senior lenders will not allow mezzanine debt to be part of the capital stack. The addition of mezzanine debt holders can complicate legal structures.
Debt financing is attractive to investors that want a fixed expected return on a monthly basis. The downside is the lack of tax benefits to this type of investment. The income is taxed at ordinary income tax rates. Another risk to debt investors is inflation. When inflation rises from 1% to 3%, the investor will still receive cash flow and interest payments that are tied to pre-inflation cost of money. Additionally, if the asset outperforms expectations, then the debt investors cannot participate in this upside.
Common Equity and Preferred Equity
Equity is always at the top of the capital stack and typically involves ownership. Equity is usually the riskiest position within the capital stack but can result in equity owners receiving the highest return on their investment. Equity is usually broken down into two categories: common equity and preferred equity.
1. Preferred Equity
Preferred equity is considered to be slightly senior to common equity and benefits from preferential treatment in the capital stack. Preferred equity has predetermined minimum payments tied to a legal operating agreement. Preferred equity investors in most instances do not receive any of the upside beyond the contractual payments. However, they receive a higher payment than a senior debt and mezzanine debt holders.
2. Common Equity
Common equity is at the highest level in the capital stack. It is the riskiest position but has the greatest return. Since common equity owners are at the riskiest position, there is no fixed term for ownership and the bulk of their returns come at the disposition of the asset. When an asset performs well, the equity owners are rewarded with the biggest ROI. Equity investors also have tax benefits, such as depreciation, that can help offset other passive income streams.
Breakdown of capital stack equity and debt percentages relative to total capitalization.
How does Anvaya Investments position itself in a capital stack?
At Anvaya Investments, we position ourselves at the top of the capital stack. We enter commercial real estate investments as common equity investors and owners of investment properties. The principal of Anvaya Investments has executed this strategy with zero losses in the last 12 years. The Anvaya Team follows a disciplined approach to real estate development and investments. The team has a deep expertise and conducts extensive field research with third party feasibility experts alongside their own due diligence. This approach helps Anvaya Investments’ stakeholders and investors reduce their risk and exposure. It also allows them to be at the top of the capital stack and return outsized returns to their investors and stakeholders while keeping their initial capital safe.
Why should investors understand capital stack?
Understanding the capital stack and ownership structure is extremely important. Every real estate investment is unique and has varied capital structures. Investors must conduct their own due diligence to see what their risk tolerance and investment goals are. Based on that assessment investors can better understand which position to invest in the capital stack.