Investing in commercial real estate is profitable on several counts. It enables you to have a regular source of income, provides a hedge against inflation, entitles you to various tax benefits, and appreciates your property’s value.
But before investing in any real estate deal, whether as an investor or a lender, you should be aware of the risks involved, the potential for returns, repayment priority, and similar aspects.
The best way to assess a property dealer’s present and future implications is by using a capital stack commercial real estate transactions. Without a clear idea of these, you risk entering a deal that could prove costly later.
A capital stack consists of the four primary capital sources required for purchasing and managing a property. It is represented through a diagram where the layers are stacked in a hierarchical order, with the most important one occupying the lowest position.
However, if you have limited knowledge about it, here’s some information you will find helpful.
Advantages of using the capital stack
As mentioned above, using the capital structure helps investors and lenders understand the risk and profit potential associated with a deal. But that’s not the only advantage.
Using the chart lets investors and lenders identify their position in a real estate transaction. It is also helpful in understanding the order of priority, arranged from the lowest to the highest. Those with the least seniority and high associated risks occupy the top position and vice-versa.
Investors and creditors can use the stack to identify the claims hierarchy, where some layers would enjoy priority over others when taking ownership of a property if the borrower defaults on their payment. For example, senior lenders usually have the right to confiscate a borrower’s property if they default on their payment obligations.
Arrangement of priorities in the stack
The capital stack contains an arrangement of priorities, in which senior debt occupies the topmost position, followed by mezzanine debt. Senior creditors are always the first to receive a payment, followed by others. Further, mezzanine creditors must have their approval before participating in a commercial deal.
Between the two equity investors in the structure: common and preferred, the latter has priority over the former. They are the first to receive payments or cash flow monthly or quarterly.
Common equity, owned by the property sponsor, receives the lowest priority. They usually earn their payments only after the other parties in the stack have received theirs.
The four layers of a stack
As seen above, the four stack layers are senior and mezzanine debt and preferred and common equity. Here are some more things you should know about them.
They enjoy the lowest risk compared to others, but that comes at the cost of getting the lowest returns on their investment. However, many lenders prefer choosing this capital because it allows them to claim a borrower’s property in case of default.
They sit above the senior creditors in the stack diagram. Like senior creditors, they receive their payments on a monthly or quarterly basis. However, they have a higher rate of return on investments and, consequently, work with high risks.
Common and preferred equity
These receive the highest return for their risks and occupy the top position in the capital stack. Syndicators or property managers offer equity to passive investors to cover the costs between the purchase price and senior debt.
Preferred equity investors receive a guaranteed payment monthly or quarterly, but common ones don’t enjoy any guarantee.
A capital stack for commercial real estate transactions provides valuable information about the risks and returns associated with a deal. Before investing in equity or being involved in a real estate transaction in any capacity, including that of a lender, you should analyze the order of priorities, return potential, and risk profile.