Understanding the Capital Stack in Commercial Real Estate Investing

The capital stack is a fundamental framework in commercial real estate (CRE) investing. It represents the hierarchy of financial claims on a property and shows how risk and returns are distributed among different stakeholders. By understanding the capital stack, investors can evaluate the structure of a deal, identify potential risks and determine where their investment aligns with their financial goals.

This guide will break down the layers of the capital stack, explain their roles in CRE transactions and show how this framework can help investors make smarter decisions while building their portfolios.

What Is the Capital Stack?

The capital stack refers to the financial structure of a commercial real estate deal. It determines how income and profits from the property are distributed and outlines the order of repayment in case of default or sale. Essentially, it’s a roadmap for who gets paid when, and how much risk they’re exposed to.

Typically illustrated as a vertical stack, the capital stack helps visualize the relationship between risk and return. The top layers of the stack represent higher-risk, higher-return investments, while the bottom layers are lower-risk, lower-return.

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The capital stack applies to a range of commercial real estate investments, including multifamily apartments, office buildings, retail centers, industrial spaces, hospitality properties, mixed-use developments and more.

The core components of the capital stack are divided into two broad categories – debt and equity financing – each with subcategories that we’ll explore below.

The Structure of the Capital Stack

The capital stack is structured as a hierarchy, with each layer representing a different level of risk, return and repayment priority. Starting from the bottom (lowest risk) to the top (highest risk), the layers are as follows:

1. Senior Debt: Lowest risk, first to be repaid.
2. Mezzanine Debt: Moderate risk, repaid after senior debt.
3. Preferred Equity: Higher risk, repaid after all debt obligations.
4. Common Equity: Highest risk, last to be repaid but with the potential for the highest returns.

To understand how income flows through the capital stack, imagine a property generating profits. Payments are distributed starting from the bottom of the stack (senior debt holders) and move upward. If there’s insufficient cash flow, layers higher in the stack, such as common equity, may not receive any returns, reflecting their higher risk profile.

The Capital Stack Layers

1. Senior Debt
   At the base of the capital stack, senior debt represents the lowest-risk layer. It is secured by the property itself, which means that senior debt holders are the first to be repaid from property income or liquidation proceeds. If the property underperforms, lenders holding senior debt can foreclose on the property to recoup their investment.

   Borrowers are responsible for paying interest, fees and principal on senior debt. Because the risk is minimal, the returns for senior debt holders are the lowest in the stack.

2. Mezzanine Debt
   Mezzanine debt sits above senior debt and carries slightly more risk. While it is unsecured (unlike senior debt), mezzanine debt holders may negotiate for partial guarantees or rights to take an equity position if the borrower defaults.

   Mezzanine debt typically offers higher returns than senior debt and is paid at a fixed rate regardless of the investment's performance.

3. Preferred Equity
   Preferred equity carries less risk and offers more consistent returns than common equity because it holds a higher repayment priority in the capital stack. Preferred equity holders receive payment before common equity but after all debt obligations.

   Preferred equity investments are often classified as "hard" or "soft." Hard preferred equity holders are entitled to payments regardless of cash flow, while soft preferred equity holders receive payments only if the property generates sufficient income.

4. Common Equity
   Sitting at the top of the stack, common equity represents the riskiest investment layer but offers the highest potential returns. Common equity holders are the last to be paid, meaning they only receive returns after all debt and preferred equity obligations are met.

   Unlike other layers in the stack, there is no cap on the potential returns for common equity. However, if the property underperforms or sells for less than expected, common equity holders could lose their entire investment.

How the Capital Stack Impacts Decision-Making

For CRE investors, the capital stack is more than a theoretical framework – it’s a critical decision-making tool. It influences several factors, including:

• Weighted Average Cost of Capital (WACC): The mix of capital stack layers can affect the cost of a deal. For example, using more senior debt (which has lower costs) can reduce WACC, boosting potential returns.
• Risk Management: By reviewing the capital stack, investors can assess the level of risk they’re taking on and decide which layer aligns with their risk tolerance.
• Returns Optimization: Investors can strategically position themselves in the stack to achieve their financial goals. Risk-tolerant investors might opt for common equity, while conservative investors may prefer mezzanine or senior debt for steady, predictable returns.

Benefits of Understanding the Capital Stack

1. More Efficient Use of Capital
   Leveraging layers like senior debt with lower interest rates allows sponsors and investors to maximize the value of their equity contributions. By limiting upfront equity requirements, they can take on larger projects or diversify their portfolios.

   Example: A developer might use 70% senior debt to acquire a property, leaving 30% of the funding to come from equity sources. This lowers the weighted cost of financing the deal.

2. Access to Diverse Funding Sources
   The capital stack enables investors to combine different types of financing, such as mezzanine debt or preferred equity, rather than relying on a single loan. This flexibility can result in lower financial risk and tailored repayment terms.

   Example: A property owner seeking to renovate may layer mezzanine financing on top of their existing senior debt, using it as a bridge loan.

3. Risk Diversification
   The capital stack makes it possible to allocate risks and returns across multiple parties. Investors can choose where they fall within the stack based on their appetite for risk.

   Example: A risk-averse investor might select senior debt for guaranteed repayment, while a higher-risk investor may prefer common equity to capitalize on potential value appreciation.

Final Thoughts

Understanding the capital stack is essential for evaluating commercial real estate investments. It establishes the hierarchy of claims, outlining how risk and returns are distributed among stakeholders and guiding critical decision-making.

Whether you are risk-tolerant and aiming for high returns through common equity or prefer the safety of senior debt, knowing how to analyze the capital stack will help you align investments with your goals.