Everything You Should Know About Capital Stack in Commercial Real Estate
Regular commercial real estate assets are costly. Thus, most investors lack the financial means to pay cash for them. Although this would appear to be a drawback, it presents a chance.
In general, one of the key advantages of investing in commercial real estate is the widespread availability of debt financing at usually favorable terms; yet, debt accounts for only 60% to 80% of the purchase price of a property.
The remaining funds must come from various financial sources, collectively known as the “capital stack,” which is often comprised of senior debt, mezzanine debt, common equity, and preferred equity. What is a capital stack?
What Is the Commercial Real Estate Capital Stack, and What Are Its Component
The layers of capital that go into buying and running a commercial real estate asset are referred to as the capital stack. It specifies who and in what order will receive revenue and profits from the asset. In the event that the equity owner defaults on the mortgage, the capital stack also specifies who has the first right to foreclose on the asset used as collateral.
The capital stack typically consists of the following four components:
- Common Equity
- Preferred Equity
- Mezzanine Debt
- Senior Debt
Priority is given to senior debt above all other capital stack components. So, before any other investor receives a return on their investment, senior debt lenders must be paid. The mortgage lender or another debt holder with the most extraordinary claim on the underlying asset is often referred to as the senior debt in the capital stack.
The lender can seize ownership of the asset through a foreclosure proceeding and sell the asset to recoup the debt if the borrower doesn’t make the mortgage payments, making it the least risky situation. Because it keeps the asset as collateral, it is the capital stack component with the best security.
There may occasionally be a discrepancy between the amount of debt that the senior lender is prepared to offer and the amount that can be raised from equity investors. Mezzanine debt, which is similarly backed by a lien on the property in these circumstances but is subordinate to the senior loan holder, fills this gap.
Mezzanine lenders are in a somewhat riskier position than senior debt holders since they are second in line to receive money generated by the property. As a result, mezzanine debt carries a premium interest rate.
Due to its evolving nature in recent years, preferred equity is a word that might be unclear when referring to the capital stack. The phrase previously referred to a form of capital that functions similarly to common equity but has better payment rights.
Since the Global Financial Crisis, it has changed to operate more like subordinate debt and receives a fixed return without profit-sharing rights. Still, it also has improved rights to take over a project in the event of default.
This progression resulted from lenders realizing during the Global Financial Crisis that mezzanine lenders had more rights than anticipated, which made it harder for holders of first-position assets to collect when borrowers default. Lenders progressively forbade the use of second-position loans, including mezzanine debt, in order to stop this from happening again.
Lenders often require developers or sponsors to invest some of their funds via common equity, also referred to as “having skin in the game.” Common equity, the riskiest but most lucrative component of the capital stack, is contributed by the people who run the property on a daily basis, the sponsor or operator, and their investment partners.
After all other capital holders have been paid, the common equity holders are entitled to reoccurring payments from the property’s cash flow. After all other creditors’ loans have been serviced, this is often paid in the form of a favored return on their investment, which is paid for out of available cash flow. Equity investors often do not have a cap on their return potential if the property performs adequately.
Factors You Should Consider When Building Your Commercial Real Estate Capital Stack
Like any investment, commercial real estate capital stack has a number of variables that might affect risk as well as potential returns. Here are some factors that investors should consider:
Cash Flow Stability
An investor can forecast with varying degrees of confidence how sustainable that cash flow may be over the long term by looking at the rent rolls of a commercial real estate asset.
Due to different business strategies, equity investments’ risk/return profiles vary greatly. The risk/return potential of any given CRE investment will depend on various factors, including the project’s complexity, future/current cash flow, lease-up rates, and rent rolls. A key element in risk mitigation is having an expert sponsor drafting and carrying out a thoughtful business strategy.
Location and Market
A commercial real estate project’s success or failure is significantly influenced by its location. For example, your risks will be lower in a market like Tampa because of the region’s favorable qualities for both businesses and employees, including its attractive climate, broad job base, and other positive characteristics.
In contrast, you can have less competition and possibly higher profits in markets with lower demand, but you’ll be more susceptible to market shocks and downturns.
How Do CRE Projects Get Capital?
Are you a commercial real estate investor or business owner looking to buy commercial real estate? Whether you’re looking for office space, a warehouse, or any other commercial property, the loan application procedure can be time-consuming and difficult. Many companies are unsure of where to begin.
There are several ways to get funding, including traditional and alternative funding options.
Any loan obtained through a conventional institution, such as “banks, credit unions, savings and thrift institutions, life insurance companies, hedge funds, pension funds, private financial institutions, etc., is considered a traditional loan. Most people think of traditional loans when considering paying for a CRE property.
The requirements for loan acceptance vary depending on the institution, whether it be a bank, credit union, or private financial organization. Some of these requirements could be:
- Maximum loan amounts
- Sufficient credit history
- Minimum credit scores
Each of these criteria differs from one institution to the next. Despite this, receiving loan approval through traditional funding can be quite challenging.
Alternative Funding Options
Any form of funding that a traditional institution does not provide is considered alternative financing. One may choose to use alternative financing to assist their investment if traditional financing isn’t looking too promising. Alternative funding has several advantages, including:
- Faster turnaround
- More flexibility
- Simpler application process
A fast turnaround is a major bonus for many investors and business owners who require funds immediately. With alternative finance, your project may, in some situations, be financed shortly after the application procedure. Alternative funding examples include Hard money loans that private investors usually finance, crowdfunding, asset-based loans, bridge loans, private money loans, etc.
No position in a capital stack is “bad” for investors or lenders; every position is advantageous to the party. Their other investments and portfolios should also influence the impression of an investor’s stake in the deal. A person with a generally conservative portfolio might, for instance, wish to accept the risk of a common equity investment or vice versa.
The project’s duration should also be considered, as senior and mezzanine debts are typically shorter-term investments than equities because they are paid off first when liquidating. Investments in preferred and common equity have a more significant potential for longevity.
Depending on the size and scope of the CRE deal, common equity investors should be prepared to have their capital constrained for at least a few years. Investors should understand that the capital stack is simply one step in the process of analyzing risk, despite the fact that it offers useful information about the risks connected to investment.
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Our CRE marketplace connects supply and demand using a unique, preference-based algorithm, matching brokers with the lenders who can seal the deal. Finance Lobby alleviates virtually all of your stress and makes your job as a commercial mortgage broker effortless, so sign up today and enjoy the advantages.