Financing of Commercial Real Estate and the Capital Stack
In commercial real estate, it is often said that finance is king. In other words, before contemplating a project, examine how it will be funded. Without a fully defined and executed finance strategy, also known as a capital stack, a substantial amount of money remains a mere concept. Before thoroughly analyzing transactions, prospective investors should acquaint themselves with the many accessible possibilities. In light of this, this article will present a summary of commercial real estate finance and the capital stack.
Specifically, the following themes will be discussed:
- Overview of the Commercial Real Estate Capital Stack
- Categories of Capital Stack Financing
- Final Reflections
Overview of the Commercial Real Estate Capital Stack
Capital stack in commercial real estate refers to the several financial layers utilized to fund a specific transaction. To comprehend this notion, consider the act of buying a property. Consider that a bank will offer you a loan-to-value (LTV) ratio of 80% to acquire a $500,000 property. This LTV correlates to a $400,000 mortgage; therefore, a $100,000 down payment would be required.
Your $100,000 contributed capital would be on top of the capital stack, while the $400,000 mortgage would be on the bottom. This placement in the capital stack is directly proportional to seniority, risk, and returns. The more senior the finance source, the lower it is on the capital stack. In this sample, if you sold your property, you would be required to pay the outstanding mortgage before receiving any proceeds.
This concept indicates that the riskier the funding source, the higher it is on the capital stack. For instance, if the value of your property declined when you sold it, you may not recover your original $100,000 investment – or any investment. The more excessive you are on the capital stack, the greater your upside potential is to compensate for this risk.
To illustrate this upside potential, say that your home’s worth will climb to $1,000,000 in a few years. When you sell the possession, the lender receives no more money than the outstanding loan amount plus any applicable interest and fees. As an equity investor at a riskier position on the capital stack, you recoup your initial investment and earn a considerable return depending on the company’s rising value.
Categories of Capital Stack Financing
A commercial real estate capital stack typically consists of five types of finance. These categories are not present in every transaction, but investors should have a working knowledge of them anyway. Below, the capital stack types are arranged from least senior (common stock) to most senior (senior debt):
Shared Equity
Shared equity is often comprised of the cash given by a deal’s sponsor or a general partner (GP). As the most minor senior type of financing, everyday equity investors get money last when a property is sold or refinanced. However, they often have a greater return rate depending on their deals’ solid performance, compensating them for this additional risk.
Preferential Equity
The next component in the capital stack is preferred equity. This often comprises the financial commitment made by limited partners or equity investors. These investors are subordinate to debt financing but subordinate to common equity. As a result, they usually obtain a preferred or mandated rate of return on their money. And, if the transaction is successfully completed, they will earn a portion of the transaction’s upside as equity investors, although at a lesser rate than joint stockholders.
Mezzanine Financing
Mezzanine finance is often hybrid financing that combines loans and equity. If a transaction needs cash to bridge the gap between debt and equity funding, the sponsor may get mezzanine financing to make the transaction possible. This is often a debt instrument with the option to A) buy out or B) convert to equity. In contrast to junior and senior loans, however, mezzanine lenders often lack a documented lien on the underlying property.
Typically, private lenders provide mezzanine finance to deal with sponsors.
Junior Debt
Junior debt is the second-most senior form of borrowing in the capital stack. This category often includes second mortgages and other construction or renovation loans secured in addition to the primary mortgage. Junior debt thus has the second-place lien on a property. Due to its subordinate status, junior debt charges higher interest rates and often has shorter durations than senior debt.
For instance, some years after acquiring an apartment complex, you get a second mortgage to refurbish a portion of the apartments. This loan would likely have a one- to three-year interest-only duration. If a bankruptcy filing during the rehabilitation term, this loan would be repaid after the senior debt but before any outstanding mezzanine financing or equity.
Senior Debt
Senior debt is positioned at the base of the capital structure. Therefore, this finance source has precedence over anything else. In other words, the lender has the primary lien on the underlying property with senior debt. In the case of a property sale (or foreclosure), the cash proceeds would be used first for this old obligation. This, however, implies that senior debt financing has no upside potential from a transaction. Lenders only collect outstanding principal, interest, and fees according to the conditions of the loan.
In most cases, the permanent mortgage of a transaction retains the senior debt position. These are amortizing loans with longer terms than the majority of junior debt. Banks or credit unions often produce these loans for minor business transactions. For more significant transactions, however, life insurance firms or Wall Street may be required to furnish these monies.
Final Reflections
While we addressed the financing categories of a capital stack in this post, we only scraped the surface of the many funding sources accessible under each category. As a novice commercial real estate investor, knowing how a capital stack works can provide you with the information necessary to assess the financing risks and possible benefits of a prospective acquisition. Understanding these categories and the general structure of the capital stack enables you to seek out diverse funding sources for specific agreements.
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