How to Read a Real Estate Capital Stack

A capital stack is the list of everyone who put money into a real estate project, ordered by who gets paid first. Lenders sit at the bottom and are paid first. Owners sit at the top and are paid last. The higher you sit, the more of the risk you carry and the more of the upside you can earn. Before asking what a project might return, ask where in the stack your money would sit.

The four layers

Most projects are financed with some combination of four pieces. Take a hypothetical $100 million building:

• Senior loan, about 55%. A bank or private lender with a mortgage on the property. Paid first, loses last.
• Mezzanine loan, about 15%. A second lender, usually secured by the shares of the company that owns the building rather than by the building itself. Paid after the senior loan.
• Preferred equity, about 15%. An owner with priority: it receives a target return before the common owners, but has no mortgage.
• Common equity, about 15%. The owners who take the first loss and keep whatever is left after everyone else is paid.

The first two are credit: you lend. The last two are equity: you own.

Who absorbs a loss first

Losses move from the top of the stack down. If the building in our example is sold for $85 million instead of $100 million, the $15 million loss erases common equity entirely and nobody else loses a dollar. At $70 million, preferred equity is gone too. The mezzanine lender loses only below $70 million, and the senior lender only below $55 million, a fall of 45%.

That is why the same building can be a conservative investment for one person and an aggressive one for another. The building is identical. The position is not.

Who keeps a gain

Gains move the other way, but only to the owners at the top. If the building sells for $130 million, the lenders and the preferred equity receive what they were promised and nothing more. The extra $30 million goes to common equity, which doubled its money on a $15 million stake. Lower layers trade upside for protection.

Three questions to ask about any position

• How much sits below me? The money ahead of you in line is your exposure; the money behind you is your cushion.
• What secures my position? A mortgage, a pledge of company shares, or nothing but the agreement.
• How am I paid, and when? Fixed interest on a schedule, a target return, or a share of profits at sale.

How we look at it

We work across the stack and look for the position where the risk is best paid in each opportunity. Sometimes that is a senior loan, sometimes preferred equity, sometimes common equity next to a developer we know. The stack is half of the risk; the other half is the business plan, which we explain in core to opportunistic, explained. You can also move a building's value up and down yourself on our Strategies page.

Frequently asked questions

What is the safest part of the capital stack?

The senior loan, because it is paid first and loses last. Safest does not mean safe: a senior lender can still lose money in a deep downturn or a failed construction project.

Is preferred equity debt or equity?

Legally it is equity, with no mortgage on the property. It behaves partly like debt because it has a target return paid before the common owners.

Why would anyone choose common equity?

Because it is the only layer with open-ended upside. Investors who can wait and accept the first loss do it for that potential.

Infinity⁹ (Infinity Capital Asset Management, LLC) is an Exempt Reporting Adviser with the SEC, CRD# 330526. This article is educational and does not constitute legal, tax or investment advice, or an offer to sell or a solicitation of an offer to buy any security. Examples are hypothetical and simplified, and figures are illustrative, not projections. Any offering is made only through definitive documents and only to accredited investors.