In the most simplistic terms, the capital stack is the way money used to purchase real estate is layered based on risk and returns. I’ve compiled a diagram to explain it visually more easily.
At the bottom is the SENIOR DEBT – The loan normally from a bank. This position brings the largest amount of capital, anywhere from 50-80% of the purchase price, to the closing table. As the name implies, this is debt service – a loan that gets a guaranteed return. In today’s lending environment that return is low, but the loan is secured by the property AND is in the 1st position. This means if it’s not paid, the lender has the right to take ownership of the building and sell it to recoup their losses – before anyone else’s claims of non-payment can be satisfied.
Next up is JUNIOR DEBT – Basically the same concept as the Sr, except this lender normally comes in with less capital, sometimes around 10-20%, and is in the secondary position. So if Jr debt is not being paid, that lender can still foreclose, but they would have to pay off the Sr debt FIRST and keep whatever’s left. There may not even be any Jr Debt on a deal, and a lot of lenders don’t like to be in this position because it’s not as secure.
The type and source of debt can vary widely, each has its pros and cons and what type you utilize depends on the kind of deal and where in the market cycle you are – financing right is critical:
- Fannie Mae/Freddie Mac (Agency Debt): non-recourse with longer ~20 yr terms and ~25-30 yr amortizations
- CMBS (Commercial Mortgage-Backed Securities): normally large insurance companies that are a little more stringent than Fannie/Freddie
- ‘Traditional’ Banks (such as Well Fargs/BofA): normally offer 5-7 year terms with 15-20 yr ams; you’ll have to refi once the term is over
- Bridge Loans: meant to be used as a hold-over while you reposition your building so it can qualify for Frannie/Freddie, rates may be a little higher with 5-7 yr terms
Now that debt is out of the way, here is where you, the investor with EQUITY, comes in.
CLASS A PREFERRED RETURN – This simply means you get the defined return FIRST before the sponsors get any cash flow. But this “guarantee” is not secured by the building (like debt) so you can’t foreclose like a bank. This pref can be cumulative or not. For example, if there is an 8% pref but the building doesn’t meet performance expectations so in year 1 you get 5% and in year 2 you get 6%. Then surprise! Year 3 performance skyrockets… if there is a cumulative return, that means in year 3 you get 13% (8% + 5% still owed from years 1&2) and the remaining profit is split between the LPs and GPs. If the pref is NOT cumulative, then you get 8% in year 3 and still split the remaining profit with the GPs.
CLASS A COMMON EQUITY – In this Class, as an LP you get the predefined split with the sponsors – no preferred return. The equity (cash flow and any refi/sale proceeds) can be split in various ways between the Limited Partners (passive) and the General Partners (sponsors) – most commonly being 70/30 or 80/20. Let’s say the split is 80% to the LPs and 20% to the GPs… if there is a preferred return ‘class’ in the deal, they will get their pref first, then you will get 80% of the remaining profits (pro-rata to the amount invested).
CLASS B COMMON EQUITY – This class in most situations is for the operators (or sponsors) of the deal. If the split is 80/20 as in the example above, after all prefs are paid, the sponsors get 20% of any remaining profits. Depending on the structure, sponsors may also get fees for finding and operating the deal.
This is a simplistic overview to help you wrap your mind around the concept… a stack can be many levels high! At the end of the day, there’s no right or wrong way to structure a deal. Every deal is different, every sponsorship team is different, and every passive investor has different goals and tolerance for risk/reward. As you can see from the diagram, the higher you are on the Stack, the higher the return but also the higher the risk!
It’s important for you to understand what works for YOU in a deal and to invest with discernment.
As always, reach out if you have any questions and until next time… invest wisely!