Explaining the CRE capital stack
Allocating capital is a nuanced process; individual investor criteria, and the most appropriate risk/return profile, must be considered. One way to simplify any investment decision is to look at the capital stack.
There is no right or wrong position in the capital stack; instead, it provides a risk/return continuum for investors looking to place capital. While the multiple layers of the capital stack can be related to any investment, below, we will explore its relevance to Commercial Real Estate (CRE).
While some real estate investments may have a straightforward capital stack such as common equity and senior debt, the capital stack represented below is a more detailed example that exists in numerous forms across commercial real estate investments.
The capital stack helps investors understand where they fall in the pecking order in regards to cash flows, their risk of repayment and, ultimately, whether the forecast return on investment is worth the assumed risk.
The capital stack has two main components; Equity and debt.
Equity sits at the top of the capital stack. Equity investment in CRE is considered to have a higher level of risk, as equity investors are only paid after debt investors. Therefore, a higher return is required to compensate for a lower capital priority. Higher returns are generated by arbitraging the difference between debt repayment costs and the income performance of the property. Additionally, equity investors receive the highest benefit (if not all the benefit) of the capital appreciation in a property. The upside available is intended to compensate for the additional risk incurred by equity investors.
Debt is the most secure tier of capital and the foundation of the capital stack. Capital at the debt level is most often directly collateralized to the property title, which provides a substantial degree of recourse and security to the debt provider. The interest on the debt is paid before equity investors receive a return. The higher level of security in a debt investment means that the required return on capital is lower than equity participants.
Equity & debt can be divided into 4 subcategories:
1. Common Equity
Return on common equity is directly tied to the performance of the asset. Being the primary benefactor of asset appreciation, investors in this layer have the potential to generate very high returns. Common equity investments receive periodic payments and have high exposure to capital growth, as long as the asset is performing. In the instance of an underperforming or depreciating asset, common equity investors are in the riskiest position of the capital structure.
2. Preferred Equity – Hybrid Capital Instrument
Positioned between debt and common equity, preferred equity holders require a higher return than debt holders. Preferred equity investors will often have a hurdle rate, meaning that they will receive all (or partial) payment before common equity holders. Due to the additional security over common equity holders, preferred equity will often gain a lower share of appreciation upside.
3. Mezzanine Debt – Hybrid Capital Instrument
Mezzanine debt holders only get paid after the senior debt. Due to this, they require a higher return on capital. As mezzanine debt is a hybrid capital instrument, the terms of this debt are often unique to each investment. The return profile at this layer increases through either higher interest rates, some share of appreciation upside, or a blend of the two.
4. Senior Debt
Senior debt is considered the bedrock of the capital stack. If an asset is performing, the debt holders will receive their full periodic payment before anyone else in the capital stack. In the instance of asset underperformance, senior debt holders can initiate a foreclosure process and liquidate the property. In this worst-case scenario, senior debt holders have a right to recover their original capital investment before any other investment layer. As this layer enjoys the most protection of all investor participants, the return on capital is generally the lowest in the capital stack.
Investors need to understand their place within the capital stack when investing in CRE. The capital stack helps investors know where they fall in the pecking order in regards to cash flows, their risk of repayment and, ultimately, whether the forecast return on investment is worth the assumed risk.
Jasper's platform allows investors to build a portfolio across all parts of the CRE capital stack; this includes tranches such as Mezzanine and Senior debt which have traditionally been inaccessible to most. It's an entirely new and better way to invest in Commercial Real Estate.
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