Real estate investing is generally considered a very stable income vehicle. But this actually hinges on the investor’s position within the capital stack. In this article, we’ll explain the capital stack and why all investors must learn its importance.
Debt Vs. Equity Financing
Before illustrating the capital stack, investors should first understand the difference between debt financing and equity financing. Lenders like banks, credit unions, and crowdfunding sources provide debt financing in the form of loans for real estate projects. Often, commercial and residential real estate purchases use more debt financing than equity financing.
Equity refers to cash or capital directly invested into the project. Investors, realtors, developers can all fund equity financing with cash. It’s important to remember that debt financing usually covers the majority of real estate purchases. Capital stacks usually consist of senior debt, mezzanine debt, preferred equity, and common equity with senior debt encompassing the largest share of the investment.
Picture This Capital Stack
Imagine an object like a triangle or a prism, with an open, narrow top and wide, closed base. Now, imagine this object is empty. In order for a real estate investor to purchase property A at $500,000 (list price plus rehab cost), he needs this object filled with that much money. The investor secures a loan from lender X (debt financing) for 80 percent, or $400,000, of the list price, he drops this money into his prism piggy bank.
He then secures another $50,000 from lender Y (debt financing), which he also deposits in his prism. The investor fronts $25,000 (equity financing) using his own cash and collects another $25,000 in cash (equity financing) from the developer. This also drops it into his piggy bank.
To recap, the investor now has a prism with four levels of capital:
- Level 1, the bottom level, (Senior Debt) from lender X: $400,000
- Level 2 (Mezzanine Debt) from lender Y: $50,000
- Level 3 (Preferred Equity) cash from the investor: $25,000
- Level 4, the top level, (Common Equity) cash from the developer: $25,000
The investor now uses the money in his prism piggy bank, from top to bottom, to purchase the property, rehab it, and pay for any associated renovation fees. Then, he sells the property for $600,000. Visualize the investor pouring this money back into his empty piggy bank. The senior debt, or bottom level, takes precedence, therefore, the $400,000 plus interest, returns to Lender X.
Then, lender Y receives $50,000 plus interest, followed by the $25,000 paid back to the investor and developer. The equity financiers, the investor and the developer, receive the remaining money, with the developer receiving a bigger portion because of his position at the top of the capital stack.
Capital Stack Position
Where does Sharestates lie within the capital stack? In the safest position, the senior debt or first lien position. While the bottom of the capital stack doesn’t earn the highest rewards, it holds the lowest risk. This position is usually backed using the property as collateral. Therefore, if the project is a bust when the property sells, the first lien position/senior debt receives its money first, then the mezzanine debt, followed by the preferred and common equity positions.
Yes, the top positions reward the biggest returns but also expose the equity financiers to the highest risk. What if our investor spent more than his $500,000 piggy bank because of unforeseen damages? And what if the property sold for less than $500,000? The loss incurred falls upon the equity financiers at the top of the capital stack.