The Real Estate Capital Stack

Sources of funding to close a real estate deal are known as the “Capital Stack” and each component may play a role in the financing of a multifamily real estate transaction.

Capital Stack
The Capital Stack is the organization of capital used to finance a real estate transaction. More importantly, the agreements for each component of the stack define who has the rights, and in what order, to the cash flow and profits generated by the asset throughout the investor’s holding period and upon sale. For most deals, there are 4 common components in the Capital Stack, which is illustrated in the diagram to the right:

• Senior Debt
• Mezzanine Debt
• Preferred Equity
• Common Equity

Senior Debt
Senior debt is most commonly associated with a bank loan and it’s often the primary source of capital in the capital stack. It usually makes up the largest portion of the financing, usually 65% – 75% of the purchase price, and the holder is first in line to receive periodic debt service payments.

It’s considered the least risky component of the capital stack and, as a result, usually provides the lowest return. In exchange for accepting a lower interest rate, the senior debt holder is entitled to a first position lien on the property, which gives them the ability (and right) to initiate the foreclosure/liquidation process in the event of a default. Once the property is sold, they’re also the first to be repaid.
Mezzanine Debt

On occasion, there may be a gap between a property’s maximum supportable loan amount and purchase price that isn’t filled by the equity raise. In these instances, the borrower may opt to seek mezzanine debt to plug the hole and close the deal.

Mezzanine debt is a loan, not secured by the property, but by a pledge of the ownership interest in the purchasing entity. Mezzanine debt holders are second in line for periodic debt service payments and typically enjoy a slightly higher return than senior debt holders to compensate for the elevated risk.

Because the Mezzanine Debt holders don’t have a claim on the underlying property, their ability to initiate the foreclosure process is limited and often only in agreement with the senior debt holders. Upon sale and/or liquidation, they are second in line to be repaid.

Preferred Equity
Preferred Equity isn’t a loan, but an investment in the ownership entity. Preferred equity holders sit below debt holders, but above Common Equity holders in the Capital Stack. As such, they require higher returns than debt holders and profit participation upon sale (if available).

However, in the event of a foreclosure and the resulting liquidation, Preferred Equity holders are third in line to be repaid and may only receive a fraction of their initial investment back, if anything.

Common Equity
The last component of the Capital Stack is the Common Equity holders, who also have an equity interest in the ownership entity, but sit behind the Preferred Equity holders. As such, their position is the riskiest and they require the highest returns. But, they also benefit the most from a profitable sale.
In the event of a foreclosure and the resulting liquidation, the Common Equity holder is the last to be repaid.

Summary and Conclusion
Whether you’re investing in a deal led by someone else or leading one on your own, it’s critically important to be aware of the construction of the capital stack and who’s entitled to what. In addition, it’s imperative to understand exactly where your investment falls in the stack and to be compensated appropriately for the level of risk taken.