Financing is key to successful real estate investing. You’ve aligned your financing with your real estate investment strategy, and are comfortable that you can execute your plan. As a result, you may have a conventional mortgage, and secondary debt as well. The term Capital Stack is used to describe the various levels or layers of financing that go into purchasing or improving a real estate project.
Why is this an important concept to understand? A successful real estate program on a specific development will result in all participants getting paid. Not all financing sources however, have the same priority. Understanding the Capital Stack insures that you understand the relative risk associated with each level of financing participation. And ultimately, whether the proposed real estate investment plan will yield the intended rate of return.
What you Need to Know
As the diagram above suggests, there are typically 4 levels of capital, however there is really no limit, in theory, to how many layers or classes of financing a capital stack may contain.
The important concepts to keep in mind are that:
- Risk increases as you move higher in the capital stack
- Each source of capital has seniority over the capital source above it, in the capital stack
- Each source of capital is subordinate to the capital source below it, in the capital stack
Since risk increases as you move higher in the capital stack, it follows that returns generally do as well, with the Junior, or Mezzanine lender typically earning a higher rate of return than the Senior debt holder.
What are the Implications?
The important concept here is that in the event of the sale or refinancing of the property, the capital stack participants at the bottom get compensated first, and once fully paid, and to the extent that there are excess funds, subsequent participants (i.e. up the capital stack) will be compensated as well.
If a real estate development plan is strategically implemented, and the business plan is properly executed, all participants will be paid. The relative position in the capital stack will however reflect risk, and the potential for compensation will be commensurate. If there are losses upon a property sale or refinancing, losses are incurred from the top down.
There is no right and wrong position in the capital stack. Savvy real estate investors may either participate as financiers, or receive the benefit of various levels of capital in their own projects. Understanding the concept of the Capital Stack allows for a better understanding of risk, and the ability to generate higher real estate investment returns.