Capital Stack

A capital stack refers to the breakdown of a real estate investment's funding structure. It shows how a development project or commercial real estate purchase is financed in order of priority, arranging senior debt, mezzanine debt, preferred equity, and common equity by seniority.

Understanding the capital structure of a commercial real estate investment helps investors and creditors gauge potential risk, returns, and repayment mechanisms for better decision-making. The managing party or sponsors primarily use it to determine the priority of payments to lenders and investors in case of financial distress or liquidation of the fund.

The capital stack in real estate represents the breakdown of funding sources for a development project or commercial property. It systematically organizes different levels of capital based on their risk and return profiles, ranked from high to low. Common equity carries the highest risk and potential returns in this structure, while senior debt is the safest, typically offering lower interest rates.

The two primary sources of financing are:

1. Equity: Equity funding is provided by investors who have an ownership stake in the real estate. They benefit from capital appreciation and may receive a share of the profits generated by the property.
2. Debt: Debt consists of various mortgage loans and other financing sources, with lenders receiving interest income along with principal repayment.

The capital stack is crucial for decision-making regarding the repayment of funds in cases of financial distress or default. It establishes a payment order that typically prioritizes senior debt first, distributing any remaining funds to common equity holders.

The capital stack structure comprises four critical sources; however, their percentage contributions may vary based on the funding strategies and investors in the segment:

1. Common Equity: Common stocks involve the maximum risk and returns, as they provide investors with ownership rights.
2. Preferred Equity: These equity investments have the privilege of being repaid before payments are made to common equity holders. Thus, they represent an equity arrangement with a security feature.
3. Mezzanine Debt: Mezzanine financing serves as a middle ground between equity and senior debt, combining features of both.
4. Senior Debt: This is one of the real estate’s capital structure levels that holds the lowest risk and return, as determined by the loan-to-value (LTV) ratio. A lower LTV indicates a safer investment, and it is sourced through mortgage loans and other debts.

The capital stack in commercial real estate is systematically structured based on seniority, risk, and reward. Below is the order of priority in this context:

1. Common Equity: Common equity is one of the riskiest sources of capital, with equally high return potential. However, it is placed last due to its excessive risk profile.
2. Preferred Equity: This is the second level of the capital stack, serving as a subordinate form of debt. It provides fixed returns but no profit-sharing avenue. Since it is riskier than mezzanine financing, it is positioned after it.
3. Mezzanine Debt: This follows in the hierarchy, as mezzanine debt offers higher returns but involves greater risk, leading to a higher rate of interest for lenders.
4. Senior Debt: Senior debt contributes the most and represents a significant portion of the stack, accounting for approximately 75% of the total financing. 

The capital stack in real estate can be understood with the help of the following examples:

Example #1

A housing society development project required a capital investment of $1.5 million. The capital stack for this project is structured as follows:

• Common Equity: 10% ($0.15 million)
• Preferred Equity: 10% ($0.15 million)
• Mezzanine Debt: 5% ($0.075 million)
• Senior Debt: 75% ($1.125 million)

In this case, the majority of the capital investment came from debt funding, which accounted for 80% of the total financing. Specifically, 20% of the financing was sourced from preferred and common equity, while the remaining 80% was acquired through debt sources, including senior and mezzanine debt.

Example #2

Town Lane, a recently established real estate investment firm, has successfully closed its first fund, Town Lane Real Estate Opportunities Fund I, raising $1.25 billion. This fundraising exceeded the initial target of $1 billion. While the fund closed in early 2024, it received a strong response from institutional investors, including university endowments and pension funds. 

The firm was formed by Tyler Henritze, a former Blackstone executive with 19 years of experience, and co-founded by his sister, Parker Morse, who had previously worked at Sycamore Partners. It is a US-focused fund with a flexible strategy across different commercial real estate sectors and the capital stack. It leverages the current market conditions influenced by rising interest rates, focusing on high-conviction, thematic opportunities in the commercial real estate sector while maintaining strong relations with the key stakeholders.

The capital structure plays a critical role in corporate finance by identifying the priority of repayment. It is significant for the following reasons:

• Order of Priority: The capital stack helps prioritize the repayment of investors and lenders in the event of fund failure, liquidation, or financial distress. Thus, the lowest levels are repaid first, moving upward in the structure.
• Determines Risk and Return: Investors can easily assess the risk and return associated with each investment opportunity at different levels of the stack.
• Better Decision Making: It assists investors, lenders, and active fund managers in making informed decisions about capital investment.
• Exploring Financing Alternatives: This structure aids in discovering various financing options for commercial real estate investments and determining the optimal mix of debt and equity financing.