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- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
About Capital Stack In Real Estate
When it comes to multi-family real estate investment there are many terms that you would come across.
One such important term in real estate investment is capital stack. In this post, we will understand what is capital stack and how it affects you as a real estate investor.
What Is Capital Stack?
It is a representation of the amount of funds required to close a real estate transaction.
As the word suggests it is a stack of funds getting paid from the bottom to the top where bottom means less risk and top means greater risk. It is the layers of capital that go into buying and operating investment in any real estate.
It determines who and in what order will receive income and profits from property. It also defines who has the first right to enclose the asset as collateral if the owner does make payments on the mortgage.
There are four layers in a capital stack which are stacked from the bottom up with their rewards and risks.
The four layers from the bottom up are senior debt, mezzanine debt, preferred equity, and common equity.
If the property in question is being sold, the first to get paid would be the senior debt and the last to get paid would be common equity. Below is a basic example.
Let’s say that you as a real estate investor purchase a property worth $800,000 with a twenty-five percent down payment. This is what the capital stack will look like:
| Type Of Capital | Amount | Percentage |
|---|---|---|
|
Equity (Down Payment) |
$200,000 |
25% |
|
Debt (Mortgage) |
$600,000 |
75% |
|
Total |
$800,000 |
100% |
In the above example, if the property is being sold, the mortgage lender will get paid first according to the stack and the remainder will be given to the equity owner(s).
If the property sells for less than $800,000, then the mortgage lender will receive the entire amount and the equity owner(s) will get the remainder.
If the sales price does not cover the lender’s amount the equity portion would be completely wiped out and the lender can choose other methods to cover the remaining amount.
What Are The Four Layers of Capital Stack?
1. Senior Debt:
Senior debt takes precedence over all other positions in the cap stack. In other words, lenders with senior debt must be paid before each investor receives a return on their investment.
Senior debt in a cap stack usually refers to the mortgage bank or lender as the one with the highest entitlement to the underlying asset.
This is the least risky position because if the borrower fails to repay the loan, the creditor can foreclose the property and cover its share after selling the asset.
The senior debt could be anywhere between fifty to seventy-five percent of the property value depending on the amount the borrower is willing to put in as a down payment and his/her creditworthiness.
Though it has the highest priority, it has the least profitable position in the stack.
2. Mezzanine Debt:
This is usually a secondary debt on the property like a second mortgage, home equity loan, or HELOC. It holds the second-highest priority in the stack after senior debt.
This means if the property is being sold, the first payment will go to the senior debt holder and the second will go to the mezzanine debt holder.
This type of debt has a higher risk compared to the senior debt hence and has better returns.
That is why the interest rates on the second mortgage, HELOC, or home equity loans are higher compared to the primary mortgage.
3. Preferred Equity:
After the mezzanine debt is paid the next payment preference goes to the preferred equity holders.
Preferred equity holders enjoy higher returns compared to senior or mezzanine debts but have a higher risk in case of default as the senior and mezzanine debts will be paid first.
4. Common Equity:
Common equity holders are positioned at the top of the cap stack. They get the best returns compared to any other positions and have the highest risks as well.
If the property is being sold they are last to receive the capital which makes the common equity holder position the riskiest in the cap stack.
Conclusion
Every real estate investment requires planning and as an investor, it is important to know the risks and benefits of real estate investment.
A capital stack is the best way to determine your position as an investor and how you can benefit from the investment.
The percentage of shares in the senior debt, mezzanine debt, preferred equity, and common equity will help you understand the risks and rewards that are included in the real estate transaction.
