The demand that is required when crafting a commercial real estate project can overwhelm any project sponsor. Therefore, you need to seek sufficient capital from other sponsors or financial institutions to fill your financial gap regarding capital and investments, and using commercial real estate capital stacks can help.
As an investor or partner, you should get the correct figures and logistics in balancing the risks and rewards for your fellow financiers and the project.
Using a commercial real estate capital stack to understand financial composition (debt and equity) helps you keep tabs on the project’s needs and performance and manage your return expectations.
Continue reading to understand how capital stacks influence the success of real estate investors.
What Is Commercial Real Estate Capital Stack?
Capital stacks are commercial real estate investments that are developed when you organize your different financiers and layers of funding according to debt, equity, and rewards. The rule in lending and investing is there are higher risks that often attract higher dividends, and lower risks have low rewards.
Most project sponsors rely on banks and other financial institutions for a significant portion of their capital contribution. These institutions assess your project, track record, and project potential before committing a certain amount to your project.
Type of Investment
There are two ways in which an investor can fund a real estate project: debt or equity. In debt, you repay the investor with interest, while in equity, the investors own a stake in your commercial real estate project.
Investors can decide on their lending option by looking at your equity, risk vs. reward, and potential ROIs in your capital stack. Investors should look at the sponsor’s capital structure to understand the risks, know the rewards as potential returns, and the venture’s profitability.
This also determines how and when you’ll earn from the project’s profits. It outlines who’ll get paid first when the project loans and debts are in default, unsustainable, or on the property’s income.
Investors can pick these details from capital stacks’ four tiers and characteristics to understand where you lie in the hierarchy of funding and payouts.
Risk Levels in Investment
Debt investments have lower risks since investors co-sign your debt to collateral, assuring you of recouping your principal amount even if the project fails. You have more access to the cash flows and have a regular repayment plan to pay off the debt. Additionally, there is an exit strategy in debt financing.
The returns in debt financing are pretty low as compared to equity financing. You can earn a lot from equity financing through different avenues like appreciation or sales. However, equity financing has higher risks as you get paid last after the debt financiers.
The General Capital Stack Model
The capital stack model has four tiers subdivided into the debt and equity layers for each type of investment. For example, debt financing has a mezzanine and senior debt investors.
Senior debt is the lowest tier and usually offers the capital required to add to your project’s equity. The investor can assume ownership or claim the first payout when selling the property.
The next tier is the mezzanine layer. Some sponsors add other hybrid investors to fill the senior debt and common equity gap. These investors can assume ownership if the real estate numbers dwindle or the project fails.
Equity investors are next, where you have the standard and preferred equity investors. These investors claim a stake in the property and capital stacks structure. For example, suppose your real estate projects require $10 million from the survey and imagination to completion.
In that case, you can have 5 million dollars from senior debt, $2 million from common equity, and having preferred and common equity share the remaining percentage. It is the most common model (in rates) in most capital stacks.
Senior debt contributes most of the project’s funding and is a general partner in your project. In addition, banks or financial institutions offer mortgages or other financial facilities to boost your project.
Given their primary contribution, they have the most security and authority in the project’s finances, and you periodically repay these loans or investments back with interest over time.
Suppose your real estate project gets liquidated or fails to honor the loan repayments. In this case, the senior loan gets top priority in deciding on liquidation procedures and payments and the sale or recovery of the underlying project.
These investors can access your cash flow and any collateral against the loan. They can also tell if you can’t meet your expectations to make liquidation or project recovery decisions to recoup their investment.
Additionally, senior loans are a low-risk option but also get less rewards than other investors. The access to the project assets assures the investors that it’ll pay off. However, investors don’t benefit much from the profit margin, hence the rewards.
Furthermore, banks will inquire about your ability to pay back the loan. That is why your track record and worth help them decide if and how much they’ll award you for the project’s capital.
It is also important to keep in mind that senior investors will assume ownership of your project if you fail to pay your monthly obligations or sell off the project or part of the project, based on their assessment and recovery plan.
Mezzanine debt fills in the gaps that senior loans and equity leaves in financial contribution. Sponsors search for extra investors who can chip into the project. However, this primarily consists of private lenders or banks that step in as short-term financiers to ensure you complete your project.
It has a high-interest rate to cover the increased risks in this layer. With higher stakes come higher rewards. Mezzanine debt has a larger share of the profits and income than senior debts.
You also have to repay the loans and investments periodically to cover the debt given. Investors analyze the sponsor’s offer on the rewards, risks, and contract offer before committing to the project.
If your project fails or doesn’t live up to its potential, mezzanine debtors could take up some portion of your equity to recover their investment. This is why it is important to draft an intercreditor agreement that spells out the necessary steps and procedures in emergencies or contingency plans when the project fails.
Finally, since the senior loan has authority over ownership or liquidation, you can convert your debt into equity as a mezzanine investor.
With preferred equity, investors receive periodic payments from the cash flow after investing in real estate. There are no guarantees in the amount of money you earn or lose, thus posing one of the highest risks in capital stacks. You can compare it to debt with set returns in various periods.
There is a high risk of losing your capital if the project fails because there is no security that protects you when investing. That is why it’s called preferred equity, because you get paid after the other debt levels but before common equity investors.
It has high returns on capital when the real estate record’s numbers are also high, making it the go-to option for some investors.
The topmost tier in capital stacks is common equity. Common equity consists primarily of private investors or other groups that choose to invest in a project for high returns. It differs from preferred equity in terms of structure and components.
Preferred equity has some mezzanine debt elements in the payouts but has similar returns and risks as common equity. You get your returns from cash flow distributions resulting from property appreciations, amortization, property sales, refinancing, and reported profits periodically.
Additionally, common equity investors can reap high rewards from these project returns if the project succeeds. Conversely, a failed project often brings more losses to these investors as they get paid last and risk losing their principal investment.
Why Do You Need a Project’s Capital Stack?
Capital stacks help investors understand a project’s financing structure. After viewing the structure, you can tame your expectations and better understand your investment.
For example, if you want to venture into a project as a senior investor, you’ll know what to look for in the project sponsor or the majority equity holders. Also, you can protect your investment better if you understand the project’s structure.
By signing different contracts between the senior and mezzanine debts and the equity holders, each investor understands their roles and could project their returns based on the project’s numbers and real estate capital stacks.
Importance of Commercial Real Estate Capital Stack
With capital stacks, investors can understand the sponsor’s goals and ambitions. There are numerous factors to consider when investing in real estate, such as the viability and projection of the ideas, risk vs. rewards statistics, and ROIs. You can analyze each aspect to know which layer suits your investments.
Investors also understand the different exit strategies on each tier to make them comfortable while investing. If you’re trying to make money, go for equity investments, where you can have high returns on your investments based on performance and profits.
An elaborate exit strategy while composing your capital stacks reduces your losses and educates you on possible problems and solutions.
Invest in Commercial Real Estate Capital Stacks Today
How does commercial real estate capital stack affect your property development project? Using capital stack works to finance a property development project fully. However, the financial complications of enormous capital demands can take a toll on your planning.
Instead of stalling or slowing your project because of insufficient plans, rally investors using your project plan and expectations. Contact EXtrance today to learn how we can help you maximize your commercial real estate investments.