One tool available to investors for evaluating and comprehending risk in direct real estate investments is the capital stack. For the purposes of commercial real estate, the capital stack is the different layers of financing sources that go into funding the purchase and improvement of a real estate project.
Ideally, a real estate investment hits its business plan or pro forma target and everybody gets paid according to plan. But, like any investment, real estate has risk. The capital stack provides investors with information about where they fall in the order of cash flows, what that order means for risk of repayment, and whether the targeted return on investment is worth the assumed risk.
While there is theoretically no limit to the number of layers a capital stacks may contain, here are the four most commonly used types of capital in ascending order of priority:
When viewing the capital stack depicted above:
- Each capital source has seniority over all capital sources located above it in the capital stack.
- Each capital source is subordinate to all capital sources located below it in the capital stack.
- Upon sale or refinance, the bottom position gets paid first until fully repaid and so on.
- To the extent that there are insufficient funds to fully repay all capital then losses are incurred from the top down.
- Risk increases as you move higher in the capital stack; this also means that returns may increase.
- Sponsor co-investments are most often contributed as equity at the highest position in the capital stack.
It’s important to understand that, in a capital stack, there is no right or wrong position but each position can incur more or less risk. In exchange, these positions may entitle different potential cash distributions. By understanding the capital stack, you have better chances of making an informed decision as to where you feel comfortable in the capital stack. You should carefully review each offering in detail and consult with your legal, tax, and financial advisors before making an investment on the Marketplace.
For more information on capital stacks, view this article: Understanding the Real Estate Capital Stack.