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Cedar River Properties Newsletter-(4/1/23)-Capital Stack

Good morning everybody!

This week’s newsletter will discuss the capital stack when it comes to real estate. A capital stack shows how equity and debt come together in a real estate deal along with who gets paid first and who has the biggest risk/reward position in the deal.

Investing in real estate usually consists of matching up equity and debt to fund the purchase of the property.

Some people will look to pay the full purchase price in cash to avoid having a mortgage on a property, but the majority of real estate transactions consists of both debt and equity.

This is for two main reasons:

1. Most people do not have enough capital to purchase a deal with all cash (especially commercial real estate)

2. Using debt can create higher returns since you have less capital tied up in the deal.

Equity usually consists of investor’s capital, whereas debt will most likely come from a bank or financial institution.

When putting them together, you get a capital stack. (See below)

The bottom of the capital stack is senior debt, which is the mortgage from the bank. The bank is in the safest position possible as they are the ones who get paid first each month with debt service and would also get paid first in the event of a default.

The highest part of the capital stack is the common equity, which would have the highest risk, but also the highest reward. This would be the majority of the investors in the deal.

Preferred equity tends to be investors that bring larger amounts to the deal and could even include institutional investors. They tend to get a higher return for their larger investment and would be below common equity in the capital stack.

• Mezzanine debt is when a hybrid debt issue is subordinate to another debt issue from the same issuer.

• Mezzanine debt bridges the gap between debt and equity financing and is one of the highest-risk forms of debt—being subordinate to pure debt but senior to pure equity.

(Investopedia.com)

It is important to know where you are in the capital stack so you can see how the money is distributed.

Most investors are usually at the top of the capital stack. This is common as investing involves a level of risk and reward.

However, as long as the investment was correctly analyzed and the business plan executed through different market cycles, then the chances of the deal working out increases.

I hope this was helpful. As always, let me know if you have any questions!