If you’re looking into financing a commercial real estate project, how familiar are you with the term “capital stack”? In a real estate transaction such as this, the capital stack refers to all the sources and the organization of funding that will contribute to the financing of a commercial real estate project.
This “stack” of capital has a hierarchical nature to it in much the same way as any physical building will. The foundation, or base, is the most secure.
There are four main areas of a capital stack that an investor may fit into:
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
Each layer, or block, has its own risks and potential rewards.
The two bottom layers are debt investing — investment capital is lent to the borrower for the purchase or development of a property. There’s more security in this form of investment as there is generally a method for lenders to recover their investment should the borrower default.
The top two layers are equity-based investing. This essentially turns the investor into a shareholder that will entitle the investor to a share of the profits. You take on more risk at these levels because they are the last to receive payment should the borrower default.
Senior debt is the base of the capital stack, and it’s the most secure. Investors at this level will receive payments before anyone else — kind of like a reverse waterfall effect. Senior debt is commonly a mortgage and makes up the lion’s share of a capital stack. This level has the added protection of the property as collateral. In the case of default, the lender takes ownership of the property.
This level is generally a place for investors looking to fill a funding gap left by the mortgage. This level involves marginally more risk. Should the property default, the senior debt still needs to recover their investment first.
Preferred equity is a better place than common equity as investors will be paid out before common equity investors. There is, however, substantially more risk than senior or mezzanine debt.
Another benefit that preferred equity investors may enjoy is an equity incentive. At a future date, the investor could receive a reward based on equity ownership when the business reaches specific goals or when the lender exits the investment. This is known as an “equity kicker.”
This is the level with the highest risk. At this level, lenders are the last to receive any repayment on their investment in the case of default. But like with other high-risk dealings, there’s also the potential for higher returns than capital or asset appreciation here, which makes the risk worthwhile for some.
How to Approach Capital Stacks
As with any form of investing, you need to consider your risk tolerance when deciding where to invest.
An MIC is an excellent way to invest in real estate in the lower, more protected, levels of the capital stack.
MICs deal with the debt end of real estate by providing mortgages to projects that don’t otherwise qualify for traditional loans. Therefore, investors are more protected as part of an MIC than as an equity investor in the top levels of the capital stack.
If you want to invest in real estate with more protection, get in touch with Jordan on our team today. Cooper Pacific has been a mortgage investment corporation for over 20 years. We’re committed to helping investors diversify their portfolios through debt funds and the real estate market.