What is the Capital Stack?
This lesson is an overview of:
Senior Debt
Junior Debt
Preferred Equity
Common Equity
Today, we're talking about the Capital Stack. The Capital Stack is a description of all
of the different types of financing that go into a project. In real estate, the Capital Stack shows us what types of debt and equity were used to finance the transaction. Most investment real estate deals have at least two or three layers in the Capital Stack, and this is because most real estate investors get their capital from more than one source, particularly because of the advantages that can be gained from using leverage.
The Capital Stack is laid out in position of priority with those at the bottom of the stack having first priority over those positions above it. Simultaneously, each of those positions indicates a different level of risk and expected return, with senior debt being first priority, having the lowest risk and therefore the lowest expected return, with common equity being last priority and having 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, sometimes called mezzanine debt, is next in line in priority and is typically more expensive because of that higher risk. Junior debt can be often critical to the success of a transaction because often senior debt holders will only lend up to maybe 60 or 70% of a project, and unless the equity holders are able to come up with that additional 30 to 40%, then mezzanine or junior debt is necessary. Sometimes junior debt can be called "bridge financing" because it bridges that 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 it's very flexible in how it can be structured. It can be structured like debt with a fixed coupon or interest rate and a maturity date, or it can be structured like common equity where it has a preferred return and a percentage of the total profits.
Common equity is the riskiest and potentially the most profitable portion of the Capital Stack. Common equity holders are usually required by the other stakeholders in the Capital Stack to inject some of their own capital to show that they're willing to take on some of the risks that the others are taking on as well. Common equity holders typically don't get any sort of fixed return, but rather in exchange for taking on the risk of being last in line of priority, they typically reap the windfalls of all remaining profits and additional income after the other stakeholders have been satisfied.
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