The Capital Stack In Real Estate & What it Means As An Investor
There are plenty of factors that need to be taken into account when determining if a real estate investment is a good fit for your portfolio.
Obviously, the details regarding the property itself are essential, but equally as important is the type of investment and where it fits into the capital stack of a development. Understanding where your investment sits in the capital stack provides insights into when it gets paid relative to others in the capital stack, its level of risk, and how payment occurs.
In this article, we'll take a deep dive into the real estate capital stack, giving you the knowledge required to effectively perform your due diligence on potential real estate investment opportunities. Here's what we’ll cover:
- What the real estate capital stack is
- The four layers of the capital stack
- The benefits and risks of each of the capital stack layers
- How Parvis offers a range of opportunities tailored to each accredited investor
What Is The Capital Stack in Real Estate Investments?
The capital stack is an extremely valuable tool for investors looking to evaluate the risk and projected rate of return for a potential real estate investment. Most large-scale real estate developments are funded by multiple sources of capital. The capital stack represents the underlying financial structure of a real estate deal and highlights the different types of capital invested and how they relate to one another.
The Capital Stack's Priority of Payments
Where your investment sits on the capital stack determines its priority in relation to the other types of capital being invested in the real estate project. The bottom layer (senior debt) in the stack will be paid out first, and the top layer (common equity) is the last to get paid out. The priority of payments is less important if all goes well and the investment is a success providing returns for all investors. However, if things go poorly and a default or bankruptcy occurs, being in a position where your payment is first to get paid is highly beneficial.
Common Layers of a Capital Stack
Although a real estate development can theoretically have more layers, the above image is a visual representation of the capital stack that includes the four most common types of capital:
- Senior debt
- Mezzanine debt
- Preferred Equity
- Common Equity
Here we will cover the differences between debt and equity, and go into each of the four layers in more detail.
When you invest in debt, you are taking part in the lending of capital required to develop or purchase a property. As a debt investor, you will receive payments in predetermined installments. That said, no investment is guaranteed to succeed; if things don't go according to plan and a default occurs, debt holders typically have a path to recover some or all of their investment. This makes debt investing much less risky than equity investing.
Senior Debt: Senior debt sits at the bottom of the capital stack, giving it first priority of payment over the other types of capital investment. This type of debt is most often a mortgage that uses the property as collateral and is usually the type of capital that takes up the largest share of the capital stack. Investing in senior debt offers a reduced level of risk, as the lender can take over the property's title through foreclosure and sell it to recover its investment.
Mezzanine Debt: Mezzanine debt is often used to fill any gaps in financing after senior debt and equity financing have been obtained. Unlike senior debt, mezzanine debt is not collateralized by the property. Instead, it is secured by the stock or equity of the company that owns the property. Mezzanine debt has priority of payment over all equity investment; only senior debt gets paid before it.
When you invest in equity, you are purchasing an ownership stake in the property. You will share in the profits (e.g. dividends) and the value of your ownership stake will increase if the property does well. Equity investments have more inherent risk than debt as they are the last tranche in the capital stack to be paid out. However, with that added risk comes the potential for higher returns.
Preferred Equity: Preferred equity is often looked at as a hybrid of equity and debt investments as it can carry qualities of both. Preferred equity can vary quite a bit, ranging from "hard" to "soft." Hard preferred equity positions operate similar to mezzanine debt, offering a fixed rate and maturity date. It also generally includes enhanced rights to take over a project if a default occurs. Meanwhile, soft preferred equity investments operate as more of an equity investment sharing in the profits when the investment does well with payment priority over common equity. Your rights and ability to recover your initial investment in the event of a default are more limited as a "soft" preferred equity holder than a "hard" one, making it riskier. Because of this, returns are generally higher with soft preferred equity positions.
Common Equity: Common equity investments are the riskiest on the capital stack as every other layer of the capital stack must be paid off before it. With this risk comes the potential for the largest returns –there is usually no cap on potential returns when an investment is performing well.
The common equity investor is in charge of the investments day-to-day operations and any major decision regarding the investment. This is why most commercial real estate developments require the general partner to purchase common equity so that they have "skin in the game." This requirement broadcasts confidence in the ability of the project achieving its targeted returns.
What the Capital Stack Means To The Accredited Investor
As outlined above, there are multiple layers of capital that can go into the funding of a real estate project. As an accredited investor, it is essential that you understand the real estate capital stack so that you can make an informed decision when investing in real estate.
Depending on your risk tolerance and goals, you will want to allocate your investment in different layers of the capital stack. More risk-tolerant investors looking for higher returns will likely look to take either a preferred or common equity position in the real estate capital stack. Meanwhile, a risk-averse investor may look to invest in senior debt or mezzanine debt which typically has lower returns but is more secure due to its seniority over equity when it comes to the priority of payment.
As an accredited investor, it's also essential to understand how the different layers of the capital stack distribute payments. If you want a more steady, lower-risk investment that pays out a set amount, a debt investment may be the best choice for you. On the other hand, if you want a higher risk, higher reward investment with uncapped returns that relies on the property performing well and achieving capital gains, then an equity investment may be your ideal choice.
The Capital Stack & Investing With Parvis
At Parvis, we have a deep understanding of the real estate capital stack and plenty of experience working with real estate developers to structure their projects' equity and debt requirements. We've utilized our knowledge, experience, and industry connections to bring high-quality real estate investment opportunities. For example, an offering on our platform, a 60 unit Residential Rental Property, provides participation in $7.3M of common equity with a targeted return of 15.4% to accredited investors.
Through the use of our intuitive blockchain-backed investing platform, Parvis accredited investors have the ability to take part in sizeable institutional-level real estate investment opportunities at every level of the capital stack. This allows you to invest in whatever type of capital will best help you achieve your financial goals at a level of risk you are comfortable with.
Sign up today to view investment opportunities and take your real estate investing to the next level with Parvis.