What does capital stack mean in real estate?

What is a Capital Stack?

In real estate, the term "capital stack" refers to the different layers of financing sources that are used to fund real estate investment projects. These layers of financing are stacked in order of priority, with each layer having different levels of risk and return. It is arranged from the most secure to the riskiest: senior debt, mezzanine debt, preferred equity, and common equity, which dictates the order in which returns are distributed to investors and the level of risk associated with each type of investment within the project.

Here's an outline of what a capital stack typically includes:

1. Senior Debt: This is the most secure layer of the capital stack and usually takes the form of a mortgage or a loan. It has the highest priority in terms of repayment and carries the lowest risk, hence offering lower returns compared to other layers. Senior debt holders are the first to get paid in the event of a cash flow or liquidation.
2. Mezzanine Debt: Positioned between senior debt and equity, mezzanine debt is more risky than senior debt but less risky than equity. It often comes with higher interest rates and may include options or warrants that allow the lender to convert debt into equity in the future, potentially increasing the lender's return if the project does well.
3. Preferred Equity: This component of the capital stack is less risky than common equity but more risky than all forms of debt. Preferred equity holders have a preferential claim over earnings and assets in the event of a sale or liquidation, ahead of common equity holders, but after all debts have been paid. They might receive a fixed dividend, which is similar to interest payments on debt, but participate in the upside potential to a lesser extent than common equity.
4. Common Equity: This is the most risky layer of the capital stack, as common equity investors are the last to be paid in the event of a cash flow or in the liquidation of assets. However, this layer offers the highest potential return, as investors gain the most from the property's appreciation in value and operational profits. Common equity involves direct ownership in the property and bears the majority of the risk since these investors are the first to absorb losses.

The capital stack outlines for investors the risk profile of their investment, their position in the order of repayment, and their potential return. It also provides insights into the leverage and financial structure of the real estate investment, informing them about the overall risk and reward potential.