No matter where you are on your passive real estate journey, you need a basic understanding of the terminology. The more you understand, the more you are prepared to make educated decisions.
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Today, let's talk about capital stack.
The capital stack refers of all of the different sources of capital that come together to finance a project.
As the capital stack outlines the types of debt and equity that ware used to finance the deal, it is a valuable tool investors use to evaluate the risks in an investment.
Because most real estate investors don't want to fund deals on cash alone, they get their capital from more than one source. Many real estate deals have two or three layers in the capital stack.
These components, or the layers of the capital stack, are organized according to priority. Those at the bottom of the stack have first priority over the positions above it. Like every investment, real estate has risk and each of these stack positions indicates a different of level of risk and expected return.
Senior debt is the first priority. It has the lowest risk and therefore the lowest expected return, while common equity is last priority, with the highest risk and expected return.
Senior debt takes priority over junior debt because it is first in line to receive the income and also first in line to receive any proceeds should the project fail and need to be liquidated.
Junior debt, which you may also hear referred to as mezzanine debt, is next in line in priority and is typically more expensive because of the higher risk.
Junior debt is often critical to the success of a transaction because often senior debt holders will only lend up to 60 or 70% of a project. If the equity holders are unable to provide the additional 30-40%, the junior debt is necessary.
This is why you will sometimes hear this junior debt called bridge financing. It bridges the gap between the senior debt and the equity.
Preferred equity is called such because it has preference in order of priority over the common equity, but the way it is structured if flexible.
It can be structured like debt, with a fixed coupon of interest rate and a maturity date, or it can be structured like common equity, where it has a preferred return and. percentage of the total profits.
The portion of the capital stack with the most potential for profit, and also the riskiest portion, is the common equity.
Common equity holders usually inject some of their own capital as a way of showing they’re willing to take on some of the risks. They usually don’t get a fixed return, but rather in exchange for taking on the risk of being the last in the priority line, they reap the remaining profits and additional income after the other stakeholders have been satisfied.
If you hear someone talking about the real estate capital stack, they’re really just talking about the different ways a property is capitalized between debt and equity.