25) Capital Stack
What is Capital Stack?
Multifamily properties, also known as apartment buildings or rental communities, are a popular investment option for real estate investors. However, financing such properties can be challenging as they require substantial capital investments. That’s where the capital stack comes into play. The capital stack is a financing structure that combines various types of debt and equity financing to fund real estate projects. In this article, we will explore how the capital stack is used in the financing of multifamily properties and the differences between the debt and equity types used in the stack.
The Capital Stack
The capital stack is a financing structure that combines different types of financing to fund real estate projects. It is a hierarchical structure that ranks the different financing options based on their seniority or priority. The capital stack includes different layers or tiers of financing, including senior debt, mezzanine debt, preferred equity, and common equity. Senior debt is the most senior layer of financing, followed by mezzanine debt, preferred equity, and common equity, respectively.
Differences Between Debt and Equity Financing
Debt financing and equity financing are two primary sources of funding in the capital stack. Debt financing involves borrowing money from lenders and paying interest on the borrowed amount. The borrowed amount is repaid over time, usually in installments. Equity financing involves selling ownership shares in the property to investors in exchange for capital. The investors receive a share of the profits based on their ownership percentage.
The primary difference between debt and equity financing is the level of risks involved. Debt financing has a lower risk than equity financing because the lender has a priority claim on the property in case of default. Equity financing has a higher risk because the investor’s return is dependent on the property’s performance. Debt financing also provides a fixed return to the lender, whereas equity financing provides a variable return based on the property’s performance. Debt financing is almost always less expensive than equity financing.
Senior debt is the most senior layer of financing in the capital stack. It is a type of debt that has a priority lien on the property, meaning that it has the first claim on the property in case of default. Senior debt is usually provided by banks or other financial institutions and has the lowest interest rate among all the financing options in the capital stack. Senior debt is also the most conservative type of financing, as it has the least amount of risk.
Mezzanine debt is a type of financing that sits between senior debt and equity in the capital stack. It is a higher-risk financing option that provides a higher return than senior debt. Mezzanine debt is usually provided by private equity firms or hedge funds and has a higher interest rate than senior debt. Mezzanine debt is subordinated to senior debt, meaning that it has a lower priority claim on the property in case of default.
Preferred equity is a type of financing that sits between mezzanine debt and common equity in the capital stack. Preferred equity is a hybrid between debt and equity, meaning that it has some characteristics of both. Preferred equity is a higher-risk financing option than mezzanine debt but has a lower risk than common equity. Preferred equity provides a fixed return to the investor, usually in the form of dividends. Preferred equity is also subordinated to senior and mezzanine debt.
Common equity is the most junior layer of financing in the capital stack. It is a type of equity financing that provides the highest return to the investor but also has the highest risk. Common equity is the last in line to be paid in case of default, after senior debt, mezzanine debt, and preferred equity. Common equity provides the investor with an ownership stake in the property, and the return on investment is based on the property’s performance.
The capital stack is a financing structure that combines different types of debt and equity financing to fund real estate projects. The structure of the stack will vary from deal to deal and what works for you may not work for someone else. It’s always a good idea to talk to as many people as possible and understand which capital stack works best for your situation.