If you have been investing for some time now, you would know that every real estate transaction has particular requirements. These vary from one deal to the next, depending on the type of investment in question. Capital stack refers to the debt and equity contributing to its operation and growth in the corporate world. If you’re investing as a passive investor in a multifamily passive real estate deal, its structure will depend on the deal’s risk profile, objectives, and specific requirements that it might have.
Understanding the capital structure is essential because it lets you know the finances required to purchase a property or complete a transaction successfully, including internal and external funding.
The capital structure involved in a real estate deal is represented by a diagram systematically explaining the various factors. Those with the lowest risk sit at the bottom of the chart, and it also groups debt and equity separately.
But what are some more interesting things about this chart, and how is it applicable to a multifamily property deal? Read on to get the answers below.
Parts of a capital stack
As mentioned above, a capital stack refers to the equity, debt, and other factors involved in a real estate commercial transaction. It consists of two categories, debt, and equity, with the risk vs. return mentioned in ascending to descending order.
These are of two types: senior and mezzanine.
Senior debt refers to a particular amount of money a property owner must pay if they go bankrupt or out of business. It occupies the lowest position in the capital chart because it carries the lowest risk.
It is referred to as senior because it occupies a better position than the rest of the capital. Senior debt holders or investors usually receive the lowest returns on investment but enjoy the lowest risk because it is the first mortgage.
Senior lenders receive monthly payments, which may or may not include the interest, depending on the terms and conditions of the deal. When the mortgage fails to make its monthly payment, the senior debt is the first to be recovered through a lien on the property.
It is a subordinated debt (which comes into effect after the existing debts are paid off). Mezzanine debt is called subordinate because it occupies a lower position than senior debt.
Investors in this debt usually receive a higher return rate than seniors. However, the risk potential is high. The lenders get their interest payments every month.
Since the mezzanine is subordinate to the senior, the former requires the latter’s approval to be a part of a commercial real estate deal. The two parties enter an intercreditor agreement, laying down the receiving terms for each if there’s a default on a property.
Common and preferred equity
Passive investors in a multifamily commercial transaction can invest as common or preferred equity. Equity investors occupy the highest position in the capital diagram because they carry a high level of risk.
However, both equity and preferred shareholders receive high returns because they lack the security enjoyed by senior and mezzanine debt. Equity shareholders have a lot of benefits, including a lack of a ceiling on their returns and receiving a part of all equity generated through forced appreciation and amortization.
You should know the various aspects of a capital stack and the positions occupied by the parties involved in a property deal. It categorizes debt and equity separately while clearly showing you its risk vs. return potential.