When calculating risk on a property investment, real estate investors have several tools they can use. One of the most useful resources is the “capital stack”. The term refers to the different financial sourcing layers that go into funding the purchase of a real estate project. In an ideal world, a real estate investment would hit its target, and everyone would receive payment according to plan. However, like any standard investment, real estate has its risks.
The capital stack provides investors with useful information about where they come in the pecking order of cash flow, and what the order means for their repayment. While there’s no specific limit on the number of layers capital stacks can contain, this article will look at the four most common: common equity, preferred equity, mezzanine debt, and senior debt.
Explaining Preferred Equity and Common Equity
Preferred equity is one of the toughest components of the capital stack to understand. It’s highly flexible, and it gets its name because holders of preferred equity will have a better chance of receiving payments than standard equity holders. Preferred equity can range from “hard” preferred equity to “soft” preferred equity which is more likely to contain extra advantages if a real estate project performs well.
While hard preferred equity holders can make some important decisions about the real-estate development, soft holders will only have limited rights. On the other hand, common equity is one of the most profitable, but riskiest options for real estate deals. The developer in this deal will be required to invest some of their own money to have skin in the game. Investor risk in common equity is significant because every other type of capital comes before the common equity holder.
In other words, those holding common equity get paid last. However, if the property is successful, investors may have no cap on their potential returns. This means that a successful common equity project can be very lucrative.
Senior Debt and Mezzanine Debt
Other forms of a deal in the capital stack include senior debt and mezzanine debt. Senior debt is secured by the deed of trust or mortgage on the property itself. This means that if the borrower fails to pay the amount owed, the lender can take ownership of the title to the property. This makes senior debt one of the least risky investments available in real estate. However, the low risk means that returns are limited too. Senior debt investors expect a lower yield on their investment compared to equity investors in exchange for a more secure position.
Mezzanine debt sits just below senior debt when it comes to defining the order of payment priorities. Once the developer has paid their operating expenses, and the senior debt, they can then push cash towards the mezzanine debt. If the developer can’t pay on this debt, the lender will be able to take over control of the property. Mezzanine debt can have a higher rate of return than senior debt, but the return is much lower than actual equity.
Understanding the different debt structures available for real estate investors, and how they work in the capital stack is crucial for investors who want to make the most out of their portfolio. Similar to investing in bonds or stocks, the risks and returns of different debt investment options will determine an individual’s diversification strategy according to their investment goals.
Our Suite of Companies
Sharestates is a real estate investment marketplace that allows individual and institutional investors to participate in rigorously vetted debt offerings. All of the offerings on the Sharestates platform have passed through a 34-point underwriting process. Sharestates has combined proprietary technology with a proven track record of business development expertise to become the fastest growing real estate crowdfunding marketplace, doubling every year since its 2015 launch.
Syndicate Profile offers investors direct access to real estate equity investments through our online marketplace–with typical net annualized returns between 12-40%. In addition to using a 34-point underwriting system, Syndicate is able to further minimize risk by partnering with the top performing borrowers from Sharestates who are seeking equity partners. Syndicate Profile’s goal is to make these lucrative investments available to a wider audience of investors.