Understanding the Capital Stack and Risk Return relationship

In the investing world, the "capital stack" illustrates the different types of capital sources used to fund a deal and how their risk and returns stack up compared to each other. As illustrated in the picture, items lower in the capital stack entail lower risk but also offer lower returns. Conversely, items higher up in the stack offer higher returns, provided investors are willing to accept a higher risk profile. The capital stack also determines the order in which profits are shared and the order of principal distribution when the investment is liquidated.

Types of Capital Sources

In syndicated real estate, four types of capital sources are most commonly used:

1. Senior Debt, or simply Debt

2. Common Equity, or simply Equity

3. Subordinate Debt or Mezzanine Debt

4. Preferred Equity

As shown in the pictures, items higher in the stack provide higher returns but also have higher relative risk. 

Almost every deal is likely to have Debt (or Senior Debt) and Equity (or simply Common Equity) as they are the most common sources of capital. Occasionally, a deal might also additionally have either Subordinate Debt or Preferred Equity.

Let's have an overview of these.

Senior Debt

Senior debt, often provided by banks or financial institutions, is the most preferred and cost-effective funding option for syndicators. While lacking control over execution, senior debt providers receive regular mortgage payments covering principal and interest. This debt is secured by the property and has priority in returns or principal recovery.

To protect their capital against potential drops in property value, debt providers limit funding to a specific percentage of the property's current value. Currently, banks tend to finance up to 65-70% of a property's value, though this can vary based on perceived market risk.

As they have the highest priority in the recovery of their principal, senior debt investments are the lowest-risk investments in the stack. Returns are limited to the pre-agreed, generally low, interest rate due to their low-risk profile.

Common Equity

Since banks won’t finance 100% of the property's value, sponsors must arrange for the remaining capital. They do this by forming a joint venture and contributing all of the remaining capital themselves, retaining 100% ownership of the property. More commonly, they syndicate the deal and accept capital from passive investors in exchange for an ownership interest in the property.

This ownership interest is referred to as equity or common equity.

Investing in common equity offers investors the greatest opportunity to grow their capital, as any increase in the property's value due to successful execution of the business plan directly contributes to the increase in the value of common equity. However, in case of project failure, investors in common equity are the last to recover their capital.

In situations requiring substantial capital improvements, sponsors seek additional sources for funding. In such cases, sponsors may also consider accepting capital from less common sources such as Mezzanine Debt or Preferred Equity.

Mezzanine Debt

This non-bank loan, called Mezzanine Debt (also known as subordinate debt), may be provided by an institution or a large single investor. In the capital stack, Mezzanine Debt directly follows senior debt.

Similar to senior debt, Mezzanine Debt investors receive regular payments of principal and interest based on a pre-fixed interest rate. However, they are paid only after the payment obligations for senior debt are met. Because they are lower in priority than senior debt to reclaim their capital, they are higher up on the risk scale compared to senior debt. Due to higher risk, Mezzanine Debt investors typically receive higher interest rates.

Preferred Equity

Investing in preferred equity, like common equity, provides investors with a share of ownership. However, preferred equity investors sacrifice some potential upside to reduce their exposure to risk compared to common equity investors.

As equity holders, preferred equity investors are lower than any debt holders in priority to receive returns and to recoup their investment in the event of liquidation. However, they enjoy higher priority and lower risk compared to common equity holders.

Conclusion

As you can see, even if many investors may be investing in the same deal, their risk and returns may look very different depending on the type of investment they make. Therefore, understanding the capital stack can help investors make more informed decisions.