Capital stack

The capital pile represents the totality of all the different financial components that make up and support the capital structure of a project. It has all the financial variables that the means provide, for example, acquiring an extension of land for development, financing the horizontal and vertical development of a planned unit development (PUD), recapitalizing the structure to accommodate the purchase of the partners, etc. . The various components of capital occupy different levels of the risk / reward spectrum and require commensurate compensation for their place of risk in the going concern structure, in the event of default or projected unrealized returns. The availability of capital is essential for the viability of financing commercial real estate projects. It represents the lifeblood of organic and inorganic property portfolio growth, the ability to capture the flow of transactions, and the myriad of financial maneuvers to strengthen a principal’s balance sheet. Capital in its various forms is essential for the CRE’s operation and is imperative for the soundness of the property’s financial structure. Generally, most real estate transactions are financed with a combination of debt and equity in various permutations.

Senior debt: it is the first debt instrument that encumbers a property that has a priority lien with respect to the subsequent ties in the order of registration. If foreclosure becomes imminent depending on the value of the underlying collateral, other minor liens in the state may be eliminated if there is not enough equity in the capital structure after the first lien holder is compensated. The first mortgages could be considered the fundamental capital in the financial structure on top of which other capital is added to the mix as needed to complete the pile. This capital may include most of the capital required to transact with the addition of the sponsor’s capital to meet the total amount required.

Junior debt – is the second, third or other junior debt instrument that encumbers a junior property in a state of lien, sequence of registration or made through subordination. Minor liens are considered higher risk debt on a property from a lender’s perspective due to the priority of the lien, and in the event of foreclosure, insufficient equity may remain in the property that can satisfy the debt beyond of the holder of the first lien that extinguishes all the rights of the holders of minor lien. . Lower lien holders typically require a quantified risk premium through a higher interest rate and shorter term to justify accepting the higher inherent risk of the loan; the return on investment (ROI) required by holders of lower lien should be higher in proportion to the riskier lien position in the capital structure. Junior debt instruments can possibly increase the Loan To Value (LTV) leveraged on a property through the additional bond applied to the property.

Mezzanine Capital: It is a hybrid financial instrument that can function as equity or debt filling a gap in the capital structure of commercial real estate occupying a position above senior and sometimes junior debt instruments. Sometimes, if there is a deficiency in the financing of accumulated debt or a disparity between the capital position of real estate investors and the collective debt instruments, the intermediate capital is used to close the gap. This financing is arranged to provide your provider with the corresponding risk premium to offset the level of risk associated with the return on principal and the unrealized returns. Intermediate debt, unlike senior and junior debt instruments, is generally unsecured against the underlying real estate used in financing when structured as preferred equity and is secured against property when issued as debt and used to increase the Loan To Value (LTV) of debt financing. as junior links.

Preferred Capital: is a capital contribution in which the source receives a priority return on their money at an agreed coupon rate before the sponsor gets a promotion; a percentage of the profits. This reflects the position of preferred capital in the capital structure, the risks associated with that position and the corresponding compensation required to occupy that position. This capital fills the gap between the equity capital of the sponsors and other financing, reducing the equity capital of the sponsor at risk in the project. Using preferred shares in conjunction with the other components of the capital stack increases leverage and, when structured wisely, can also increase return on investment (ROI); it represents a viable means of using external capital in real estate transactions to mitigate the risk of capital and, at the same time, give up part of the advantages of the deal.

Sponsor’s capital: is the cash contribution, the accumulated market value above the other components of the capital structure of a property or the value of other properties owned by the sponsor eligible for cross-guarantee, etc. In its simplest form, it is the usual down payment required by lenders to borrowers in excess of the loan amount provided to execute a purchase. Sponsor equity can be accumulated as a result of property appreciation and / or loan principal reduction. This creates fair value in the property that the sponsor can leverage for the portfolio pyramid, capital improvements, etc. This capital represents the sponsor’s capital at risk which, in the event of property depreciation, foreclosure, etc., is prone to contracting. Sponsors try to reduce their risk exposure by using other financial instruments available in the capital structure, reducing their cash outlay or capital at stake, and at the same time use leverage to increase cash over cash return. .

When financing commercial real estate, not all components of the capital pile are necessarily utilized. However, they are possible options that can help managers achieve their goals. How the deal is structured depends on the parties involved and their goals, the financial market, and the property. However, staying flexible and being aware of the available variables that can be used increases investors’ tool set and propensity to be effective in making deals.