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Capital Stack Structure in Real Estate

If you are an investor who is interested in commercial real estate, one of the important concepts that you need to understand is the capital stake structure. It helps you assess a real estate investment project’s risks and expected rate of return. But what is capital stack in real estate? Capital stack structure in real estate refers to the multiple layers of capital that are required to buy and operate a commercial real estate investment property.

Capital stack showcases the underlying financial structure of a commercial real estate project. In most cases, the capital stack structure is represented in a graph or image illustrations that showcase different types of capital in a commercial real estate deal that are stacked above each other in layers like a cake.

The capital stack structure is made up of two main components namely; debt and equity sections. These two components are further subdivided to represent the different types of debts and equity that are used by different real estate investors.


The 4 layers of capital in the capital stack structure

The four types of capital layers (senior debt, mezzanine debt, preferred equity, and common equity) in the capital stack structure in real estate investment are listed in order of repayment priority starting from the lowest priority to the highest priority capital.

  1. Senior debt- Senior debts have the highest priority over the other capital layers in the capital stack structure. It means that providers of senior debts must be paid first before any other investor is paid any return from the investment. Providers of senior debt are typically mortgage lenders and other debt holders who have the highest stake in the underlying commercial real estate investment property. Senior debt is the most secure or less risky position that an investor can hold in the capital stack structure.
  2. Mezzanine debt- Mezzanine debt is in the second position in the order of payment priority after senior debt. Investors under this capital layer are entitled to receive their payment after all the operating expenses and senior debts have been cleared. Since they are slightly risker compared to senior debt, Mezzanine debt providers qualify for a higher rate of return.
  3. Preferred equity- Preferred equity has evolved over time from a capital that works in a similar manner to common equity but has a high payment priority to function as a subordinate debt. It receives a fixed return but it does not share any profit. However, preferred equity providers enjoy superior rights and they can take over a project in case of default.
  4. Common equity- Common equity is provided by the project sponsor, operators, and other investment partners who have the capacity to run the commercial real estate investment property on a day-to-day basis. Common equity holders are paid the last as they have the lowest priority when it comes to payment. Also, in some instances, holders of common equity are entitled to non-guaranteed recurrent payment from the property cash flow after all the other capital holders are dully-paid.


Why is capital stack structure so important in commercial real estate investment?

Capital stack structure is one of the most important concepts for commercial real estate investment ventures. It helps an investor analyze the debt, equity, and risk-return profile of a given commercial real estate investment deal to determine whether the investment is worth the risk and commitment or not.