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Where Does Your Investment Fall In The Capital Stack?

May 1, 2024

chrisseveney

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Creating Wealth Simplified | Capital Stack

 

Capital stack is one of the most common terms in real estate investing. But what it is really and how does it impact your investments? In this episode, Chris Seveney delves into the four layers of capital stack, detailing the potential returns from each one and the various risks you must prepare for. He also presents different example investments to shed more light on capital stack’s dynamic and multifaceted nature.

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Where Does Your Investment Fall In The Capital Stack?

If you’re tired of the stock market and the rollercoaster ride or seeking an alternative way to build wealth, you’re in the right place. In every episode, we like to dive into the world of alternative investments, exploring innovative strategies and covering hidden gems that help you generate passive income, protect your hard-earned money, and plan for a comfortable retirement. Our focus and mission are to demystify the world of investing and break down complex concepts into simple, actionable steps that you can apply to your own financial journey.

We are going to talk about what the capital stack is. The simplest way I like to look at the capital stack is it is structured as a layered cake. Each layer represents a different type of financial investment in a project, real estate, or property. The layers range based on the order of priority or prepayment as well as, most importantly, risk.

Creating Wealth Simplified | Capital Stack

Capital Stack: Each layer of capital stack represents a different type of financial investment based on the order of priority for pre-payment and risks.

 

Capital Stack Layers

Making the cake at the base, we have that most secure layer, which typically is senior debt. It’s the largest portion of the financing. It’s secured by the asset itself. Like real estate and property investments, if things go south, senior debt is the first to get paid from any proceeds or liquidation. I don’t like using the word safe, but it has the lowest risk for an investor because of the security. With all lower risk, it offers lower returns, which are generally mirroring or slightly above interest rates. Being at that lowest level is senior debt, but we’ll get into other aspects. The lower you are on the cake, the lower the risk.

On top of that next layer, in many instances, it is what’s called a mezzanine debt. This sits between senior debt and above it is the equity layers. It’s a form of debt that can convert into equity if the loan isn’t paid back as agreed. These types of loans are risky. It’s riskier than a senior debt because they’re not backed by the physical real estate. As a result, they’re going to offer higher returns to compensate for this increased risk. Think of it as a middle ground. It’s not as secure as senior debt but also not as risky as the next level of the cake.

Above that mezzanine layer is preferred equity. You read us talk about our fund a lot. Our investors have preferred equity, but we don’t have senior debt. They are at the lowest. In a real estate transaction, preferred equity sometimes has characteristics of both debt and equity. It will get paid out returns before the common equity holders, but only after all the debts have been satisfied. It’s less risky than the common equity because the preferential payouts often come with a fixed rate of return.

In 7e, our investors have preferred equity. We don’t have any senior debt. There’s nothing there to get paid. As of this recording in April of 2024, we stipulate that. We don’t plan on taking on senior debt, but I do want to make sure we date this. There are no debt layers there. Preferred equity is down at the bottom. They get their interest.

The common equity, which myself and Lauren hold, we don’t get anything until after preferred equity gets everything they need, which is at that top layer, which is common equity. Those common equity holders are last in the line of payment, meaning they bear the most risk. In many instances, it also comes with the greatest potential for reward. A successful investment, after everything is paid off, common equity holders can see that return.

One of the things we like to talk about in our form posts, our show, and our webinars, when we talk about calculating our understanding of capital stack as well as investing in general, is balancing that risk and return. Each layer has its own set of risks and potential rewards. Investors need to understand where they fit within the structure.

It’s a fundamental principle that can help you guide your investment strategy in the decision-making process. I’ll give an example later on that talks about some scenarios to understand because sometimes, people only look at the number they might achieve for return without understanding what that stack looks like.

Deeper Dive

Let’s dive deeper into these layers and back to senior debt. In traditional real estate, it is the bedrock of the capital stack. It’s the most secure, and it’s a bank that steps in and provides that senior debt. If that investment does go south, that senior debt and the bank are first in line to be paid back from the sale of that asset. The risk is on the lower end of the other areas in that capital stack. Each investment will have its own level of risk. It is why banks are happy to get the interest rate on the loan. They’re the first in line.

With mezzanine debt, I’ve seen it in the past on the private side. I was building a condo building, and the owner had the bank debt, and the senior position got mezzanine debt on the deal, which rates were in the high teens, and it wasn’t secured by technically the property. If the owner developer failed, they could step in and take over the project. They’re buying out the owner as part of that.

One of the interesting features of the mezzanine is its ability to convert to equity. It cannot foreclose on the asset. They step in and take the equity. You don’t see it often nowadays. It was big several years ago. It’ll make a comeback, but I haven’t seen too much of it based on the capital tax we’ve seen, which, on traditional real estate, has been more of the senior debt, preferred equity, and common equity.

Going back to preferred equity. It is where most people invest in a fund or syndication. Understand that in preferred equity, these payments are not guaranteed. If there’s a default, senior debt will step in, foreclose on the property, and use that property as that asset. With preferred equity, a lot of people are learning the hard way, and there are many offerings. There’s no guarantee, and there’s the potential that your equity will be completely wiped out if property values drop and there is no equity left in that property.

Something that people need to understand about preferred equity is it’s great to say, “I have preferred equity. Going back to it, what is in front of you? One of the reasons why we would like to talk about this layer within our offering is that preferred equity, at this time, has no senior debt in front of it, and we don’t plan on having any senior debt. It puts the investors first within the entire portfolio of the assets we hold. Above that is that common equity component. If it’s successful, there’s that upside.

Risk Profile And Tolerance

I hope I explained some of the strategies and understand risk profile and risk tolerance well to everyone where you fall on that capital stack. The lower in the capital stack means they’ll lower the risk, but also the lower potential returns. As an investor, are you conservative, and do you prefer security? Are you a gambler and want higher returns? Are you willing to take on more risk for the potential of greater gains?

Knowing where you stand on the spectrum is crucial before deciding which layer of the stack aligns with your investment objectives. Understanding that component and the diversification is another key principle in investing. If you’re investing in an offering within where you’re at in a capital stack, understand the asset but other assets because you don’t want to put all your eggs in one basket. Not only do you want to put your eggs in one basket, but you don’t want to invest in the same layer of the capital stack throughout your investment portfolio.

Do not put your eggs in one basket. You don’t want to invest in the same layer of the capital stack throughout your investment portfolio. Click To Tweet

You can balance portfolios in risk in return. For instance, you might want to mix some preferred equity that doesn’t have debt with some common equity or preferred equity as significant debt. That preferred equity with no debt will provide you with a lower yield but should bring in more consistent cashflow. It also allows you to take more risks.

Were you thinking about stocks and how those work? If you have a 401(k), there are higher-risk stocks and more conservative ones like bonds. With stocks, you want a value risk profile. It is the same in real estate investing because each layer of the stack does influence the overall risk and return profile of your investment. The lower you are in the stack should provide a greater level of protection and regular income compared to up in the chain, where you might not see any returns until the exit of that asset.

Creating Wealth Simplified | Capital Stack

Capital Stack: The lower you are in the capital stack, the greater level of protection you get compared to when you are up in the chain, wherein you might not see any type of returns until the exit of an asset.

 

Sample Cases

Let’s talk about some examples and what does this look like. I’ll start with a real estate deal. I imagine you’re considering investing in a multifamily building, and it’s a $10 million acquisition. The sponsor says, “Here’s a capital stack structure. You’re getting a $6 million loan from X, Y, and Z bank, and I’m going to have $4 million of equity. I’ll do $2 million in preferred equity and $2 million in common equity.” Preferred equity is giving a pref of 8% flat across the board. Common equity might be 5% pref, but 50% of the upside. I’m using these as examples.

As an investor, you have $100,000 and you want to invest. You’re deciding where you want to invest in that capital stack layer. You want to invest in the pref. That is between 60% and 80% loan to value. You’ll get a higher initial distribution but not share in any of that upside, or you want a less preferred return that participates more net upside. There is no right or wrong answer. It’s what fits you.

Let’s say they didn’t have a bank loan, and they were also getting senior debt from investors. Investors could be that senior debt. It went 10%, 8%, or 5%. It is focused depending on what you’re looking for. Here comes the big but. Let’s take the same deal that has $6 million in senior debt, $2 million in preferred equity, and $2 million in common equity. The debt is paying 8%. Preferred equity is giving 10%. Common equity is giving 6% plus upside.

I also see deals where people will look at it and say, “I can get this much from this deal.” Realize you’re in an equity position versus a debt position or higher on the chain. I’ll use an example with our fund because it’s an easy one that pops into my head. We have anywhere from 8% to 11% preferred by our investors. We have no debt. They are, if you looked at a multifamily deal, in a senior debt position on the capital stack.

I’ve seen other deals where there’s debt in place, and they do have the preferred equity, but there’s significant debt in place. Let’s say there’s 65% debt. They make up the area between 65% and 100% of the deal. Instead of 8% to 115, they can get 10% to 12%. The question comes up, “If you got $100,000 to invest, would you rather have 10% and be at the lowest in the capital stack or be at 12% and be higher up in the capital stack?”

If you’re risk-averse and prioritize security, investing lower in the stack might be your best option. It may offer slightly lower returns but a less high degree of safety, but it’s less risky compared to being behind somebody else. If you’re seeing the higher returns and are comfortable with that risk, that could be appealing because it’s giving you that higher interest. If you look at a traditional bank, what do they consider a good spread between a first and second position? It’s about a 4% spread where you’ll see a bank 3% to 4%. My guess is you’ll see a first-position lien versus a line of credit or a second. That’s at 65%, and they won’t go to 100% equity. If you’re looking at one to 2% delta, banks see it as 3% to 4%. I would have to think the banks have pretty good algorithms to understand their level of risk and defaults. Is 2% good for you or not? These are things to understand between them.

As we wrap up, try to unravel these layers of the capital stack and understand where you are in them and how each layer can represent a different level of risk and return. It’s important for you as an investor to understand where you are within the structure and make sure that it aligns with your risk tolerance and financial goals.

It doesn’t matter whether you prefer more security being lower on the capital stack or the higher reward of being higher on the capital stack because the world of investing is dynamic and multifaceted. We always want people to continue exploring and learning. Whether it’s a deeper dive into capital stack or any other aspect of real estate, every step hopefully brings you to more proficiency as an investor.

Mortgage Notes

The last thing I’ll mention about the capital stack is we see this a lot in what we invest in the mortgage note space. Many offerings will say, “We invest in first-position liens. We invest in secured debt.” Most do. Understand that because that’s what they invest in, it doesn’t mean that’s what you are investing in. Let me give you an example. There are limited rights obligations or unsecured notes.

I post a lot on a website called BiggerPockets. People ask me questions all the time. I’m familiar with how to analyze a lot of offerings, especially to non-accredited investors, because they go through what’s called the Regulation A process. When we launched ours, I did a lot of research on what other people were doing and understand how to find all this information. It is rare for an offering to do what we do, which is issue shares of preferred equity and have it be at the lowest level of the capital stack.

Many will go by notes and issue unsecured notes to the investor or limited rights obligations. People will think, “I’m in first position. I’m secured.” You may be. You may not be. According to the documents, it’s unsecured. Do they have other debt? Do they have other expenses? What does that mean? When 9 out of 10 people were asked that question, they didn’t know the answer.

What they thought they were doing is because the website or the sponsor said, “We invest in first position secured notes.” They think, “I’m owning or getting a piece of that secured note. I own that specific note.” It’s not the case. Make sure you’re going to invest in any type of deal, always understand what that capital stack looks like, and understand if somebody is in front of you, what those terms are for them to be in front of you.

Before investing in any type of deal, always understand what the capital stack looks like and know if somebody is in front of you. Click To Tweet

 

Closing Words

I hope you enjoyed this episode. This is a wrap for another episode. Thank you for joining us on this journey to unlock the full potential of your financial future. We hope these insights have opened your eyes to new possibilities and helped you take a step closer to your dream of generating passive income, gaining control over your money, and securing a comfortable retirement.

Please remember that the path to financial freedom is not a straight line, but if you have the right guidance and mindset, you can make it a reality. If you enjoyed this episode, please share it with a friend, leave a review, subscribe, or follow us on YouTube. When you follow us, you will stay updated on the latest strategies and insights from the world of mortgage note investments. Until next time, keep exploring, learning, and taking charge of your financial destiny. Thank you, have a good one.

 

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