In real estate syndications, the capital stack is a concept that defines how a deal is funded and how returns are distributed.
What is the Capital Stack?
The capital stack represents the hierarchy of financial contributions to a real estate deal. Each layer has a different level of risk, reward, and priority when it comes to repayment. The four main components of the capital stack are:
- Senior Debt
- Mezzanine Debt
- Preferred Equity
- Common Equity
1. Senior Debt
Senior debt is typically the largest portion of the capital stack and comes from a bank or other lending institution. This layer has the lowest risk because it’s secured by the property itself and is paid first in case of liquidation.
- Risk: Lowest
- Returns: Fixed, typically lower than other layers
- Priority: Paid first in all scenarios
2. Mezzanine Debt
Mezzanine debt sits between senior debt and equity. It’s unsecured and carries a higher risk, but it offers higher returns to compensate. In some cases, mezzanine debt can be converted to equity if repayment issues arise.
- Risk: Moderate
- Returns: Higher than senior debt but fixed
- Priority: Paid after senior debt but before equity
3. Preferred Equity
Preferred equity investors receive fixed returns and are paid before common equity holders. This layer blends debt and equity characteristics, providing a mix of stability and upside potential.
- Risk: Moderate
- Returns: Fixed, with potential for additional profit-sharing in some cases
- Priority: Paid after all debt, but before common equity
4. Common Equity
Common equity represents true ownership in the property. It’s the riskiest position in the capital stack because these investors are paid last after all other obligations are met. However, they enjoy the greatest upside potential, participating in the property’s appreciation and profits.
- Risk: Highest
- Returns: Variable, often the highest in the stack
- Priority: Paid last
How Does the Capital Stack Impact Investors?
Understanding where your investment falls in the capital stack is key to aligning your financial goals with your risk tolerance.
- Risk-Averse Investors: May prefer senior debt or preferred equity for their fixed returns and lower risk.
- Growth-Oriented Investors: Often gravitate toward common equity for its high upside potential.
Why the Capital Stack Matters in Syndications
In real estate syndications, sponsors carefully structure the capital stack to balance risk and return. For example:
- A sponsor might use senior debt to finance 70% of the property’s purchase price.
- Preferred equity could fund 20%, providing stability for certain investors.
- The remaining 10% might come from common equity, allowing for the potential of outsized gains.
More Information
For more information, check out this BiggerPockets article.