Everything You Need to Know About the Capital Stack in Property Investment

Key takeaways:

• Know the financial structure of your commercial real estate deal with capital stack in property investment
• Learn important aspects of real estate business with Pluxa Knowledge courses.

Do you want to evaluate the real estate risk and projected rate of return of a commercial property?

Well, then you must understand the capital stack in property investment.

But what’s that?

Capital stack is one of the most valuable ways to evaluate a potential investment in a commercial real estate deal. 

It enables you to know who gets paid, at how much risk, and in what order.

That’s not it.

Let’s dive into the deeper aspects of a capital structure in property investment and gain more clarity.

What Is the Capital Stack in Real Estate?

The capital stack is the layers of capital that can help you in purchasing and operating a real estate investment. It can help you understand who will receive profits and income generated by the property and in what order.

It also defines the different types of financing used to purchase real estate and highlights who gets paid first if there’s a non-payment of the funds. 

For example, if you buy a property for $1,000,000, you pay $200,000 of your own money and borrow the rest. The capital stack ranks the different types of financial investors in a property, showing who gets paid first and who gets paid last if the property’s earnings aren’t enough to cover its debts.

There are four sections in a capital stack:

• Common Equity 
• Preferred Equity 
• Mezzanine Debt 
• Senior Debt

Let’s understand the structure in detail.

What Is the Structure of the Capital Stack?

Capitalization or capital stack includes the different sources of funding used to finance your real estate project. The funding sources that a capital stack contains and the percentage contribution are different per investment.

Here are the four common capital sources ranked in ascending order of priority.

Capital Stack	% Total	Description
Common Equity	20% to 60%	Common equity is at the top of the capital stack, which makes it the riskiest way to invest because if things go wrong, you are the last to get your money back. However, the risk comes with a potential reward as there’s no limit to how much money they can make if the investment does well.
Preferred Equity	10% to 20%	Preferred equity, also known as “preferred stock,” is a type of investment that combines elements of both debt and common equity. If things go south, preferred equity investors get paid before common equity investors but after all debt holders. The terms can vary, and it offers fixed returns similar to a loan, but with a chance to earn more if the investment performs exceptionally well.
Mezzanine Debt	10% to 20%	Mezzanine debt, also known as “junior debt” or “subordinated debt,” is a type of financing that falls between senior debt and equity in the capital stack. It’s riskier than senior debt, so it comes with a higher interest rate. It is unsecured and mezzanine lenders are paid after senior debt holders in case of default.
Senior Debt	40% to 60%	Senior debt is the largest portion of financing in real estate deals, which is similar to a typical mortgage. It is secured because the borrower has provided collateral, which makes this type of debt less risky. Because it’s less risky, the interest rates are lower compared to other types of financing in the capital stack. If things go wrong and there’s a default, senior debt holders are the first to get paid back which minimizes their risk of losing money but also offers lower potential returns compared to riskier investments in the stack.

Now that you understand the basics, let’s highlight the importance of capital stack in your real estate business journey.

Why Is Capital Stack Important?

A commercial real estate investment’s capital stack is an important concept as you need to analyze the debt, equity, and risk-return profile of a project. Also, it highlights the hierarchy of financial contributions and the order in which investors get paid back.

Here are more reasons:

1. Investment Decision-Making: By analyzing the capital stack, investors can make informed decisions about whether an investment aligns with their risk tolerance and return expectations. It helps investors understand their potential for loss and gain.

2. Risk Assessment: The capital stack shows the risk level associated with each type of investment. Senior debt is the least risky, as these lenders are paid first. As you move up the stack to mezzanine debt and equity, the risk increases. Understanding where you are in the stack helps assess the risk you’re taking on.

3. Return Potential: Different positions in the capital stack offer different return potentials. Generally, higher risk (equity) offers the potential for higher returns, while lower risk (senior debt) offers more modest, stable returns.

Apart from capital stack, there are multiple other concepts in real estate investment you must understand.

Learn From Pluxa Knowledge

We, at Pluxa Knowledge, offer online property investment courses designed to teach you how to profit from property investment in the UK. 

Our courses cover various strategies and aspects of property investment, whether in residential or commercial settings. We provide a comprehensive learning experience using our years of knowledge and research in property investment.

So, what’s making you wait?

Explore our courses and expand your knowledge horizon to make informed decisions and achieve desired real estate investment results.

FAQs

How does the real estate capital stack work?

Capital stack has layers that represent a different type of money used to finance a property. From the bottom to the top, each layer has a different level of risk and potential return.

• Senior Debt
• Mezzanine Debt
• Preferred Equity
• Common Equity