Understanding the capital stack
Real estate transactions can get very complicated. Theres a lot going on within a 30, 45, or 60 day window to close out a deal.
There’re contractors that need to be lined up. Due diligence companies on site making sure that there are no skeletons in the closet once the deal closes. And so on.
One thing that needs just as much attention as the property itself is the capital stack.
To make it simple, the capital stack is the structure of all debt and equity invested into the project.
Below is the basic structure of capital stack.
The common equity is placed at the top of the capital stack.
Common equity is the most riskiest part of the capital stack. This is because it comes second to all other payments on the capital stack.
To accommodate the risk, common equity investors are paid pro rata in the upside after other positions of the capital stack.
Preferred equity is senior to common equity, but still prioritized below the debt.
Preferred equity is compared to mezzanine debt at times.
They have a special preferred rate of return while having a time frame set for return of capital.
Mezzanine debt fills in the gap between all equity and debt.
Because there is a shortfall between equity and debt, when mezzanine investors come in, they demand a high interest rate than senior debt.
This is the foundation of the entire capital stack. Senior debt is the least riskiest.
Therefore its placed at the bottom of the capital stack.
Senior debt is paid back before ALL other debt and equity is paid. It is in first lien position to the entire capital stack.
This was just a short a sweet intro into the capital stack.
There are plenty of ways to structure a capital stack. There are dozens of debt types to fill the debt portion of the capital stack.
And there are dozens of other types of equity.
One thing that remains, is that in most cases, debt is paid senior to all other equity types.