The capital stack represents the totality of all the different financial components that are a part of and support the capital structure of a project. It has all the financial variables that provide the wherewithal, e.g. acquire a tract of land for development, finance the horizontal and vertical development of a planned unit development (PUD), recapitalizing the structure to accommodate partners buyout, etc. The various capital components occupy different levels of the risk/reward spectrum and require commensurate compensation for their at risk place in the structure as a going concern, in the event of default or projected unrealized returns. The availability of capital is critical to the viability of financing commercial real estate projects. It represents the lifeblood of organic and inorganic growth of property portfolio, ability to capture deal flow and the myriad of financial maneuvers to strengthen a principal’s balance sheet. Capital in its various forms is essential to CRE operation and it is imperative to the robustness of the property’s financial structure. Typically, most real estate transactions are financed with a combination of debt and equity in various permutations.
Senior Debt – is the first debt instrument encumbering a property that has a priority lien senior to subsequent liens in order of recordation. If foreclosure becomes imminent depending on the value of the underlying collateral other liens junior in status can be wiped out if there is not enough equity in the capital structure after the first lien holder is compensated. First mortgages could be considered the foundational capital in the finance structure upon which other capital is added to the mix as required to complete the stack. This capital can comprise the majority of the capital needed to conduct transactions with the addition of sponsor’s equity to fulfill the total amount needed.
Junior Debt – is the second, third or other junior debt instrument encumbering a property junior in lien status, recordation sequence or effected through subordination. Junior liens are considered riskier debt on a property from a lender’s perspective due to the priority of lien and in the event of foreclosure there possibly being inadequate equity remaining in the property which can satisfy debt beyond the first lien holder extinguishing all junior lien holders’ rights. Junior lien holders customarily require a risk premium quantified through higher interest rate and shorter term to justify accepting the inherent higher risk of the loan; the return on investment (ROI) required by junior lien holders has to be higher commensurate with the riskier lien position in the capital structure. Junior debt instruments can possibly raise the Loan To Value (LTV) leveraged on a property through the additional lien applied to the property.
Mezzanine Capital – is a hybrid financial instrument which can function as equity or debt filling a gap in the capital structure of commercial realty occupying a position above senior and sometimes junior debt instruments. Sometimes if there is a deficiency in the cumulative debt financing or a disparity between the equity position of property investors and the collective debt instruments mezzanine capital is used to bridge the gap. This funding is arranged to provide its provider with correspondent risk premium to compensate for level of risk associated with return of principal and unrealized returns. Mezzanine debt unlike senior and junior debt instruments usually is not collateralized against the underlying realty used in the financing when structure as preferred equity and is collateralized against the property when issued as debt and used to raise the Loan To Value (LTV) on the debt financing as junior liens.
Preferred Equity – is equity contribution in which the source receives priority return on their money at an agreed coupon rate before the sponsor gets a promote; a percentage of the profits. This is reflective of the position the preferred equity occupies in the capital structure, associated risks of that position and the correspondent compensation required for occupying that position. This capital fills the gap between sponsors’ equity and other financing, reducing the at risk sponsor’s equity in the project. Using preferred equity in concert with the other components of the capital stack increases leverage and when structured prudently can also increase the Return On Investment (ROI); it represents a viable means of using outside equity in real estate transactions for risk mitigation of capital while giving up some of the upside in the deal.
Sponsor Equity – is the cash contribution, accumulated market value above the other capital structure components for a property or the value in other properties owned by sponsor eligible for cross collateralization, etc. In its simplest form, it is the customary down payment required by lenders from borrowers above the loan amount provided to execute a purchase. Sponsor equity can be built up equity resulting from property appreciate and/or loan principal reduction. This creates equitable value in the property which the sponsor can leverage for portfolio pyramiding, capital improvements, etc. This equity represents the at risk sponsor’s capital that in the event of property depreciation, foreclosure, etc is prone to contraction. Sponsors try to reduce their risk exposure by using the other financial instruments available in the capital structure reducing their cash outlay or equity at stake while simultaneously using leverage to increase the cash on cash yield.
When financing commercial real estate, not all the components of the capital stack are necessarily used. However, they are possible options that may assist the principals in reaching their goals. How the deal is structured depends on the parties involved and their objectives, the financial market and the property. However, maintaining flexibility and being cognizant of the available variables that can be used increases the investors’ tools kit and propensity to be effective in getting deals done.