By Laus Abdo, CEO and Founder, AGP Capital and Maya Saraf, Associate, AGP Capital
In a previous edition of the Lido Newsletter, AGP outlined the benefits of investing in commercial real estate and discussed the concept of the “capital stack,” which refers to the tiers of equity and debt that comprise a real estate investment. In this edition, we take a deeper dive into the various layers of the capital stack and explore the associated risks and benefits of investing in each.
Breaking Down the Capital Stack
Real estate transactions can be capitalized in a variety of ways from using solely equity, to a combination of debt, equity, and other structured instruments. Investors will usually opt to finance a portion of a transaction with senior debt to reduce their equity contribution. Most senior mortgage lenders will not loan over a 65% loan-to-value ratio. Many investors, therefore, seek additional leverage in the form of mezzanine debt or preferred equity. These instruments occupy the middle spot in the capital stack, between the senior loan and common equity, and can provide up to a 70% to 85% loan to value.
Typical Capital Stack with Preferred Equity or Mezzanine Debt
These forms of financing have characteristics that make them riskier investments than senior loans. To illustrate how these different instruments work, let’s use an example of a fully leased, cash-flowing apartment building for sale at $10M.
$10M Apartment Building Purchase
Capital Stack #1: Senior Debt and Equity
An investor decides to purchase the building using a combination of debt and equity. They obtain a $6M first trust deed loan for the purchase, which represents a 60% loan-to-value. This loan is senior debt because it is backed by collateral (the property) and gets paid off first before any other type of debt or equity. The investor would fund the remaining $4M of the purchase price with equity. The equity is considered “Common Equity” in that it has no special priority or rights like Preferred Equity, which is described in more detail in the following sections.
$10M Apartment Building Purchase: Capital Stack #1
Relative to the equity, the debt on the property is in the most secure position because it gets paid back first. Additionally, the debt benefits from an equity cushion that protects it in case the building’s value declines. If the building’s value dropped from $10M to $8M, the debt would still have a 25% equity cushion. However, the equity investor would have lost $2M of their initial investment, highlighting the higher risk of the equity in the first loss position.
Capital Stack #2: Senior Debt, Mezzanine Debt, and Equity
Now, let’s consider an alternative scenario - the investor decides to obtain additional financing to supplement the $6M first trust deed loan, and secures a $2M mezzanine loan.
$10M Apartment Building Purchase: Capital Stack #2
A mezzanine loan is a type of subordinated debt, meaning it gets repaid after the senior debt has been paid. For this reason, mezzanine loans generally have higher interest rates than senior debt. Unlike senior debt, mezzanine debt is secured by a pledge of ownership interest in the company rather than the property itself, and it can often be converted to equity.
In this scenario, the investor needs just $2M of their own equity. However, the cost of borrowing is higher, and now two lenders must be repaid before the investor receives any return on their investment.
Capital Stack #3: Senior Debt, Preferred Equity, and Common Equity
Now let’s consider a third scenario in which the investor gets $2M of preferred equity financing instead of the mezzanine debt. Preferred equity functions similarly as a joint venture investment among multiple equity owners and sits between debt and common equity in the capital stack. It has priority over common equity in terms of distributions and default rights but is subordinate to all forms of debt. It is not collateralized by the property but has certain contractual control rights. Preferred equity gets paid only after the debt has been repaid, but before the common equity investors.
Preferred equity often requires payment of a “preferred return” akin to interest payments and may also entitle the holder to a portion of any upside, such as profits from the property’s sale. This makes preferred equity more expensive than senior or mezzanine debt. Once again, the investor contributes $2M of common equity, but in this scenario, the cost of capital is the highest due to the preferred equity structure and the potential sharing of profits.
$10M Apartment Building Purchase: Capital Stack #3
Investing along the Capital Stack
Now that we covered a few examples, let’s explore where investors can position themselves within the capital stack. Many private real estate funds specialize in different segments of the capital stack, offering different levels of risk and return. These funds pool investments such as senior secured loans or mezzanine debt, giving investors access to diversified portfolios. Choosing what type of fund to invest in depends on an investor’s goals and risk tolerance, with opportunities spanning the entire risk spectrum—from the most secure senior debt to the higher-risk common equity.
Investing Along the Capital Stack from a Risk Perspective
Senior Secured Debt
For investors seeking safety of principal and steady income, senior secured debt is the most conservative option. It is protected by collateral and is the first to be repaid. Lenders offering conservative loan-to-value ratios benefit from an equity cushion, minimizing the risk of loss. This layer offers reliable interest payments with the lowest risk of capital loss.
Mezzanine Debt
Mezzanine debt offer investors a higher yield relative to senior debt, but with additional risk. Because mezzanine debt is subordinate to senior debt, the likelihood of fully recovering the loan in the event of a default is reduced. Additionally, because mezzanine loans charge higher interest, they are more susceptible to default when borrowers are experiencing issues. These investments provide a flow of income, but with greater risk.
Preferred Equity
Preferred equity allows investors to enjoy potential upside from increased rents or profits, offering higher returns than debt investments. However, it carries greater risk than debt. In the event of a default, preferred equity is only paid after all the debt has been paid off. If property values decline severely enough, the preferred equity can be wiped out. Though preferred equity provides some downside protection, the returns are often capped in exchange for reduced risk compared to common equity. This type of investment is suitable for an investor seeking capital appreciation, but with less risk than a typical equity investment.
Equity
At the top of the risk spectrum is common equity, which offers the highest potential returns but also the greatest risk. In the event of a default, common equity is the first to take a loss and could be completely wiped out if property values drop significantly. This type of investment is best suited for those with a high tolerance for risk and a focus on long-term capital appreciation rather than steady income.
Conclusion
Understanding the capital stack is crucial for making informed decisions when investing in commercial real estate. Each layer of the stack—senior debt, mezzanine debt, preferred equity, and common equity—offers a unique combination of risk and return. Senior secured debt is the safest option, offering steady income and safety of principal, while common equity provides the potential for high returns at the greatest risk.
Mezzanine debt and preferred equity fall in between, balancing risk and reward depending on the investor’s risk tolerance and goals. By carefully selecting where to invest along the capital stack, investors can tailor their real estate investments to achieve safety of principal and steady income, moderate growth, or high-risk, high-reward opportunities.
