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The Importance of Understanding the Capital Stack

What is a Capital Stack?

A capital stack consists of the total capital invested in the project. For multifamily real estate, the capital stacks will be comprised of a combination of senior debt, mezzanine debt (optional), common equity, and preferred equity (optional). Having a clear understanding of the capital stack in each investment offering is important for developing your diversified portfolio.

Which Components Have Seniority

In figure 1 you can see how each of the various components of a capital stack are positioned. As you can see the capital stack is built from the bottom up. Each component has seniority over all other components positioned above it in the capital stack. Conversely, each component is subordinate to the other components positioned below it in the capital stack.

When asset is either refinanced or sold the proceeds are dispersed from the bottom of the capital stack and up. After each position is fully repaid, then is will go to the next and continue until all positions have been fully repaid.

If there are not enough funds to fully repay all the capital, then the losses are distributed from the top of the capital stack first. The higher positions in the capital stack are higher risk and the lower positions in the capital stack are lower risk positions. The returns will be higher in the higher positions in the capital stack. The returns will be lower in the lower positions in the capital stack.

Capital Stacks for Our Projects

Our group typically has two different types of capital stacks when we are acquiring an asset.

Three Components for Single-Tier Equity Structure

In figure 2 you can see that there are three different components to this capital stack structure. From the bottom up, there will be senior debt, Class A shares, and then Class B shares.

The senior debt is obviously for the primary loan to acquire the asset. The Class A shares will consist of the limited partners and will bring 100% of the equity required to close. Our group will typically invest about 10% of the initial equity in Class A shares alongside our passive investors to be sure our interests are aligned. The Class B shares in this capital stack are reserved for our group for getting the deal together.

When the asset is sold in this capital stack structure, the senior debt is paid back first, then the Class A shareholders will receive their entire initial capital back, then the equity split of profits will come into play which is typically 70% to Class A shareholders and 30% to Class B shareholders.

Four Components for Dual-Tier Equity Structure

In figure 3, you can see that there are four different components to this capital stack structure. From the bottom up, there will be senior debt, Class A shares, Class B shares, and Class C shares.

The senior debt, as with the previous example, is for the primary loan to acquire the asset. The Class A shares will consist of limited partners in what is considered a preferred equity position and will typically bring 25-35% of the equity required to close. The Class B shares will consist of the limited partners as well and will bring the remaining 65-75% of the equity required to close. Again, our group will typically invest about 10% of the initial equity required to close in a combination of both Class A shares or Class B shares depending on what is available as we get closer to closing. The Class C shares in this capital stack are reserved for our group for putting the deal together.

When the asset is sold in this capital stack structure, the senior debt is paid back first, then the Class A shareholders will receive their initial capital back, then the Class B shareholders will receive their initial capital back, then the equity splits of profits will come into play which is typically only available for Class B and C shareholders since the Class A shareholders in the preferred equity position are paid their higher preferred return in exchange for potential upside on the deal. The Class B shareholders will typically receive 70% of the profits and Class C shareholders will receive 30% of the profits.

Hedging Your Risks with Preferred Equity Positions

The preferred equity position is the lowest risk outside of the senior debt and it is as close to a guaranteed return as you can get in these types of investments. The deal would have to go completely south for you not to get your return. If the preferred equity does not get paid, then that means neither common equity positions would get paid either. Many of the more sophisticated investors, including institutional investors, prefer to be in a preferred equity position to lower their risks within the investment.

If you want to have a fully diversified portfolio it is a good idea to invest in a combination of both preferred equity and common equity positions.

Understanding your position in a capital stack is certainly one of the important items you should be reviewing prior to investing but there are additional considerations at play including how preferred returns are structured, equity waterfalls, distribution hurdles, etc.