Capital Stack Commercial Real Estate 101

Discover capital stack commercial real estate is, why it’s such an important tool for investors, and how to use it to structure commercial real estate financing:

 

What is a Capital Stack?

A capital stack is a combination of equity (down payment) and debt (the loans that finance your deal). It is the stack or layers of money that finance your commercial deal. Imagine a capital stack as a stack of books. The book on the bottom of the stack represents the debt, or the loan. On top of that debt we stack the equity or the down payment. If you are funding the entire down payment yourself, then we stack one book on top of the debt. But if you have an investor putting in half the down payment, the investors equity is the book stacked on the debt and then your portion of the down payment is stacked on top of the investor’s equity.

Commercial Real Estate Capital Stack

Here are three examples of how a capital stack is used to structure the financing for a commercial real estate deal. For all three scenarios the deal details are the same. It’s a million dollar deal with a down payment of $250,000 and a bank loan for $750,000.  So, one deal with three different capital stack funding structures.

Scenario 1: The first capital stack has two layers. I am providing the full down payment of $250,000 myself. So my top layer of equity is $250,000. My bottom layer is the debt and it is a bank loan of $750,000. So, I have my equity on top and the debt held by the lender on the bottom to equal a million dollar transaction. This structure is typical when financing real estate.

Scenario 2: In this scenario the capital stack structure is modified slightly and has three layers. Although I still have the debt and equity portions of the stack, the equity portion of $250,00 is broken up into two layers. I will put down $50,000, and then an investor will put in $200,000, adding the second layer. So, the down payment of $250,000 is two layers and the loan for $750,000 is at the bottom of the stack.

Scenario 3: The final capital stack has four layers. In the equity portion at the top there are two layers: my down payment of $50,000 and an investor for $150,000. That means I am short $50,000 of my $250,000 down payment. To solve this I’m going to get a seller carry second mortgage for $50,000. The debt portion is the bottom two layers. The seller financing is the third layer, and then I have my loan from the bank of $750,000 at the bottom of the stack.

Evaluating Potential Risk and Return (ROI)

Understanding the principle of capital stacking is important because it’s one of the key concepts in evaluating risk and return on investment in a commercial deal. The higher you are in the capital stack, the higher your potential return on investment. But there’s a trade off. With that high return comes more risk. At the same time, the lower you are in the capital stack, the less risk there is but it has the least amount of return.

For example, in the first scenario where I put in the entire down payment myself, I get all the returns if I sell the property for a profit. The lender doesn’t share in those profits at all. On the other hand, I also have the most to lose. If the deal fails, I could lose all the equity I put down, but the lender still gets their $750,000. The same principle applies to the other capital stacks in our examples. Those who put in the equity have the highest risk and highest returns. Whereas those who provide the debt are lower risk with lower returns.

Capital Stack Structure Simplified

Financing for commercial real estate comes from multiple sources. These sources of capital are typically broken down into four components in a capital stack and they are stacked based on potential risk and return. The four components are: Common Equity, Preferred Equity, Mezzanine Debt, and Senior Debt.

1. Common Equity is your down payment at the top of the stack and has the highest risk and return. You have the most to lose and the most gain from the deal.
2. Preferred Equity is the investor’s money or equity they are putting into the deal.
3. In architecture mezzanine is a term used for an intermediate level that is open to the floor below. In a capital stack, Mezzanine Debt refers to secondary debt like the seller carry second mortgage that bridges the gap between the equity and senior debt.
4. Senior Debt is the loan you get from a bank or conventional lender and it has the lowest risk and the lowest return. If there is a default or failure in the deal, the senior lender gets paid first.

3 Key Takeaways:

• Where you are positioned in the capital stack impacts your cash flow, risk, and your return on investment.
• The capital stack identifies who has the rights to cashflow and profits and in what order.
• It identifies or lays out the rights if there’s a default or a failure in the deal.

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