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

Senior Debt: It is the first debt instrument that encumbers a property that has a priority encumbrance over subsequent encumbrances 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 removed if there is insufficient equity in the capital structure after the first lien holder is compensated. First mortgages could be considered the foundational principal in the financial structure on top of which other principal is added to the mix as needed to complete the stack. This capital may comprise the majority of the capital necessary to conduct transactions with the addition of the sponsor’s equity to meet the total amount necessary.

Subordinated Debt: is the second, third, or other subordinated debt instrument that encumbers a subordinated property in lien status, registration sequence, or effected through subordination. Small 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 a foreclosure, there may be inadequate equity left in the property to satisfy the debt beyond the owner of the lien. first lien, which extinguishes all rights of lesser lien holders. . Subordinated lienholders typically require a risk premium quantified through a higher interest rate and shorter term to justify accepting the increased risk inherent in the loan; the return on investment (ROI) required by junior lien holders has to be higher in proportion to the riskier lien position in the capital structure. Subordinated debt instruments can possibly increase the leveraged loan-to-value (LTV) on a property through the additional lien placed on the property.

Mezzanine Capital: is a hybrid financial instrument that can function as equity or debt filling a gap in the commercial real estate capital structure that ranks above senior and sometimes junior debt instruments. Sometimes, if there is a gap in accumulated debt financing or a mismatch between the capital position of real estate investors and collective debt instruments, intermediate capital is used to close the gap. This financing is arranged to provide your provider with the appropriate risk premium to offset the level of risk associated with repayment of principal and unrealized returns. Mezzanine debt, unlike senior and junior debt instruments, is generally unsecured against the underlying real estate used in the financing when structured as preferred equity and is secured against property when issued as debt and used to raise loan to value (LTV) in debt financing for junior bonds.

Preferred Equity: An equity contribution in which the source receives a priority return on its money at an agreed-upon coupon rate before the sponsor earns a promotion; a percentage of the profits. This reflects the position that the preferred capital occupies in the capital structure, the risks associated with that position and the corresponding compensation required for occupying that position. This capital fills the gap between the sponsors’ capital and other financing, reducing the sponsor’s capital at risk in the project. Using preferred stock along with the other components of the equity stack increases leverage and, when structured prudently, can also increase return on investment (ROI); it represents a viable means of using outside capital in real estate transactions to mitigate capital risk while foregoing some of the upside of the deal.

Sponsor Equity: is the cash contribution, the accumulated market value above the other components of the capital structure for a property or the value of other properties owned by the sponsor eligible for cross-collateralization, etc. In its simplest form, it is the usual down payment that lenders require from borrowers on top of the provided loan amount to execute on a purchase. Sponsor’s equity may accumulate as a result of property appreciation and/or loan principal reduction. This creates equity in the property that the sponsor can leverage for the portfolio pyramid, capital improvements, etc. This equity represents the sponsor’s capital at risk which, in the event of property depreciation, foreclosure, etc., is prone to contraction. Sponsors attempt to reduce their risk exposure by using other financial instruments available in the capital structure, reducing their cash outlay or capital at stake, while using leverage to increase the cash-on-cash return.

When financing commercial real estate, not all components of the equity stack are necessarily used. However, they are possible options that can help directors achieve their goals. How the deal is structured depends on the parties involved and their goals, the financial market, and the property. However, maintaining flexibility and being aware of the available variables that can be used increases investors’ toolkit and propensity to be effective in making deals.