In real estate, the capital stack is like a financial blueprint for an asset or project. It shows the different funding sources in a specific order based on interest payment and principal repayment priority. The capital stack plays a significant role in determining the level of risk involved, the returns investors can expect, and, ultimately, which financing options are chosen.
Knowing how the capital stack works is important for investors who want to spread their investments wisely and stay flexible in changing markets.
Understanding the capital stack can help you make smarter choices that match your comfort level with risk and what you hope to achieve with your investments.
What Is the Capital Stack in Real Estate?
A capital stack refers to the hierarchy of different sources of funding that contribute to the financing of a real estate project.
It represents the various layers of capital — each with its own risk and rate of return characteristics – contributing to a development's overall financial structure. The components of a capital stack typically include:
- Senior debt
- Mezzanine financing
- Equity
Each occupies a specific position in terms of risk and repayment priority. Understanding the nuances of a capital stack is crucial for real estate professionals, investors, and developers, as it directly influences the project’s financial stability, risk profile, and potential returns.
The Components of the Capital Stack
The components of a capital stack typically include:
Equity
Equity refers to investors' ownership stake in a property or development project. Unlike debt, equity investments do not involve a promise of fixed periodic debt service payments. Instead, equity investors become full or partial owners and participate in the property’s performance, both in the interim and at a liquidity event, sharing its successes and potential risks.
Common types of equity investments:
- Common Equity: Common equity is the most straightforward form, representing the ownership stake held by individuals or entities contributing capital to the project. Common equity investors participate in property appreciation and income distributions, with their returns dependent on the project’s success.
- Preferred Equity: Preferred equity holders get preferential treatment regarding distributions and potential returns. These investors receive priority over common equity holders in receiving profits or recovering capital in the event of a property sale. They often agree to a guaranteed floor-level return. Preferred equity often balances the higher risk of common equity and the lower risk and return profile of debt.
These types of equity investments can be structured as follows:
- Joint Venture Equity: In joint ventures, equity partners pool their resources to share the financial burden and potential rewards, fostering a collaborative approach to property development. These ventures are usually managed by a certain individual or entity, who earns a preferential fee or outcome based on their extra work.
- Institutional Equity: Institutional investors, such as pension funds, insurance companies, or real estate investment trusts (REITs), often participate as equity investors in large-scale real estate projects. These entities frequently bring substantial capital to the table, seeking diversified and stable returns from their real estate holdings.
- Fractional Real Estate Investing: With fractional real estate investing platforms like Arrived, investors can pool their investments in single family residential and vacation homes. Platforms like Arrived can provide a lower barrier to entry and are often open to accredited and nonaccredited investors.
Debt
In the context of a capital stack, debt refers to borrowed capital that developers or property owners secure to fund their projects. Unlike equity, which involves ownership stakes, debt is a contractual obligation to repay borrowed funds over a specified period, typically with interest. Debt is leveraged to amplify the capital available for a real estate project, allowing developers to undertake larger ventures that might not be feasible with equity alone.
Some common forms include:
Senior Debt
Senior debt holds the first position in the capital stack hierarchy, often with the highest repayment priority. Lenders often have a claim on the property in case a borrower defaults or goes into foreclosure. This form of debt tends to have lower interest rates and lower returns, reflecting its lower risk profile.
Mezzanine Debt
Mezzanine financing is a funding option that blends debt and equity characteristics. It connects senior debt (traditional loans) and equity (ownership shares) in a real estate project's funding structure. Think of it as a middle ground, positioned higher than senior debt but lower than equity.
For developers, mezzanine financing offers extra funds to optimize leverage, which can potentially lead to higher returns. This financing type typically involves subordinated debt (loans that are paid back after senior debt) or preferred equity (ownership shares with priority over common equity). Repayment and returns for mezzanine financing are tied to the success of the project.
Mezzanine financing carries higher risk because it's subordinate to senior debt. However, it's attractive to investors who are comfortable with some risk because it can provide a balance between risk and reward. Mezzanine financing also typically includes equity kickers, which provide options to convert debt into ownership shares.
How the Capital Stack Is Structured
The capital stack represents a layered arrangement of diverse funding sources, with each component strategically positioned based on its risk profile and repayment priority.
This hierarchical understanding can empower investors, developers, and industry professionals to strategically align financial structures with project objectives, manage risk effectively, and enhance the overall success of real estate ventures. Here’s what the layers of the capital structure look like:
Senior Debt
Senior debt is the cornerstone in a capital stack, sitting at the top of the hierarchy.
Senior debt offers less risk, leading to lower interest rates than other financing options. Senior debt’s prioritized repayment structure can ensure that senior debt holders recoup their capital first from project cash flows or property sales. For example, the loans held in the Arrived Private Credit Fund are primarily senior debt. These loans fund projects like new construction or provide bridge loans to complete renovation projects.
Subordinate Debt
Subordinate debt, also known as junior or mezzanine debt, is positioned between senior debt and equity and holds the second position regarding repayment priority.
Subordinate debt strategically bridges the financing gap between senior debt and equity, providing developers with additional capital and offering investors the potential for increased returns. This financing layer is crucial when a project requires more funding than senior debt alone can provide without diluting ownership through additional equity. While it involves a higher risk level than senior debt, subordinate debt offers potential upsides, including higher interest rates and the option for debt holders to convert to equity.
Preferred Equity
Preferred equity is a unique financial instrument in a capital stack's structured hierarchy, blending equity and debt characteristics. It represents an ownership stake in a real estate project with preferential distribution treatment and potential returns.
Positioned below senior debt but above common equity, preferred equity offers investors a nuanced risk-return profile. It provides security compared to common equity while balancing risk mitigation and potential returns.
Preferred equity investors typically seek a middle ground between debt and equity, with predetermined terms for transparent and predictable returns.
Common Equity
Common equity signifies ownership of a property or development project. Unlike debt, common equity involves no fixed payments. Instead, investors become partial owners and share potential profits and risks.
Positioned below senior debt and other forms of financing, common equity is at the bottom of the capital stack, meaning it has the highest risk potential but can offer the potential for increased returns. Common equity investors often have voting rights and contribute to project decisions.
This type of investment can be attractive to those seeking substantial returns and are willing to accept higher risk for ownership and project involvement.
If you want to diversify your real estate investments, consider the Arrived Private Credit Fund. We’ve removed barriers to this investment vehicle at a time when high interest rates provide investors with an attractive yield secured by quality real estate.
