29 Oct Understanding the Capital Stack in Real Estate Investing
Why the capital stack is important
There are a few reasons why investors need to pay attention to the capital stack.
First, it tells you who has seniority and how much of the debt is senior. For example, if a property’s capital stack is made up of 85% of various types of debt, it’s significantly riskier to common equity holders than if the capital stack is just 60% debt-based, all other things being equal. In simple terms, common equity holders in debt-heavy situations are more likely to get left with nothing if things go wrong. A capital stack can help you make more accurate assessments of the risk/reward profile of a particular investment, especially if you’re thinking of making a common equity investment.
Second, a capital stack often tells you how much money the sponsor is contributing. This is sometimes listed as a separate type of equity in the capital stack, or it could be included in the common or preferred equity that other investors contribute. Generally speaking, it’s good to see a sponsor with a lot of skin in the game — especially if the sponsor’s equity has the same seniority level as other investors.
Third, if you’re investing in debt, the capital stack gives you important information on where you stand. In the event of default, you’re more likely to recoup your investment if there’s less senior debt, for example. And it’s not common for there to be several levels of mezzanine debt, so it tells you exactly where you fit in the order.
The capital stack is only one piece of the puzzle
As a final point, while understanding the capital stack can tell you a great deal about the risk/reward profile of real estate investments, it’s important to realize that it’s just one piece of the puzzle when doing your due diligence.
Different types of real estate deals have different risk profiles. For example, buying a modern, fully-leased apartment building can have much less risk than buying a hotel that’s in need of renovations, even if the latter project takes on significantly less debt. So be sure to consider the big picture, not just the capital stack, when trying to assess risk.