What is the Capital Stack?

Commercial real estate projects need money or “capital”. Investors can provide some or all of that capital to a project in various different structures in accordance to their needs. Types of capital are typically differentiated based on there risk and return targets, liquidity, control rights and more. Each type comes with its respective risk level and potential return. As an investor, it’s helpful to see how the investment types break down in relation to each other so you can figure out which level suits you best. That’s where the capital stack comes in.

The capital stack is a way of organizing the capital types, described by many literally in a vertical stack, based on the order in which they get returns from the property’s cash flows. Typically, senior or secured debt is on the bottom and is paid first, followed by subordinate or mezzanine debt, then preferred equity, and then common equity. However, being paid first isn’t always best because it typically has the lowest rate of return due to the lower risk level. 

Here’s a closer look at each capital type so you can get a better idea of which investment level will be best for you. 

Common Equity

Common equity investors, typically consisting of institutions, high net worth retail investors and accredited investors, are the “owners” and are entitled to the property’s cash flows, in addition to any appreciation in the property’s value after any debt or higher priority capital is repaid. This means that returns are, theoretically, uncapped. Additionally, common equity investors may be entitled to a degree of control over decisions made regarding the property, depending on the number of shares owned (akin to common equity ownership in publicly traded stocks).

Behring typically sees projects utilize common equity for 35-50% of a project in lower leverage deals and a minimum of 10-15% of the capital stack in higher leverage deals. In the higher leverage deals that include using more senior debt, mezzanine debt or preferred equity, Investors will see returns of 18% or more. In exchange for realizing this potential return, common equity investors accept the risk that, in the event things do not go well, they have the lowest priority when it comes to returning their capital. However, risk can be mitigated in numerous different ways and reputable developers have many tools to do so.

Preferred Equity

Preferred equity is seen as a “hybrid” and often blends equity and debt characteristics. In general, it refers to debt or equity investments with higher priority for a property’s cash flows or profits than common equity but lower priority than mezzanine debt.

Investors can find both “hard” and “soft” preferred equity deals. “Hard” preferred equity functions like a debt position, with a fixed coupon and a maturity date but limited upside participation. “Soft” preferred equity functions more like an equity stake with upside potential should the project do well. However, the return is often limited by a specific threshold, unlike with common equity.

Behring sees markets use preferred equity for 10-15% of the capital stack and investors can receive an estimated 12-18% return, depending on the project and structure of their position. Preferred equity investors vary, but typically consist of high net worth retail, accredited, and institutional investors.

Mezzanine Debt

Mezzanine debt or “bridge Loans”, sit beneath senior secured debt and above equity positions. Typically, mezz debt is uncollateralized and lent based on the property’s free cash flow and ability to service debt beyond what a senior loan may provide. It can be a useful way to bridge the gap between what the developer or sponsor can borrow from the bank to complete a project and the capital needed to finish it. It is riskier than senior debt but often offers higher yields.

Behring sees mezz debt account for 15-25% of the capital stack and investors can receive an estimated 8-12% yield, depending on the project. Mezz debt investors vary but typically consist of high net worth retail, accredited, and institutional investors.

Senior Debt

Lastly, the capital stack’s safest position is senior debt because the mortgage or deed to the property itself is often collateral for the loan. It also has the highest claim on a company’s assets. If the borrower defaults, you are entitled to the property. However, senior debt also pays the lowest yield because it’s collateralized and repaid before all other deal members. As a result, Behring typically sees senior debt markets willing to fund 50-70% of the capital stack and investors can receive a 3-6% yield, depending on the project, its type, location and quality. Senior debt investors vary but typically consist of institutional investors like banks seeking lower risk while accepting limited returns in exchange. Senior debt is typically compared to similar risk/return propositions like government bonds, treasury notes, high-grade corporate bonds etc.

What to look for when examining a capital stack

When examining the capital stack, the top of the stack has the highest return potential and the bottom has the lowest. As a result, common equity can earn you the most back because the returns are theoretically uncapped. However, the bottom has the least amount of risk. If the project goes under, the equity positions (senior debt and mezz debt) would be repaid first, followed by the equity positions (preferred and then common).

To decide which is best for you, you’ll want your return objectives and risk tolerance. If you’re looking for a low-risk investment that performs as expected with as little change as possible, you may want to consider a senior or mezzanine debt position. If you’re looking for more upside and are willing to take more risk, then preferred equity or common equity will be better for you.

Alternatively, if you have an existing portfolio of real estate, consider your current risk-return profile, viewed through the lens of the capital stack. If you find yourself more concentrated in debt investments like mezzanine or senior debt, then it may be prudent to allocate new capital towards a common or preferred equity position to generate a higher potential return; conversely, if your current portfolio is overweight in riskier common equity positions, consider a hard preferred equity position, mezzanine debt, or even a senior debt opportunity.

About Behring

Behring Co. is privately owned, vertically integrated real estate development and private equity platform located in the San Francisco Bay Area. Investors can partner with us and enter any level of the capital stack based on their risk and return objectives. Want to learn more? Contact Behring to discuss your investment options.