Looking back at the year we had at RealtyMogul.com and all the important milestones that came with it (like the $20 Million returned to investors that was announced last week), one stands out the most: the launch of the Commercial Real Estate Investing Platform.
The announcement may not have come with a cool infographic, but the launch was another step in the right direction for us – increasing our investors’ access to the commercial real estate investing world through passive investment opportunities, and simplifying capital raising for our sponsors and borrowers.
We have been in the Commercial Real Estate Equity business since 2013 and this launch gave us the ability to do something that not many other companies have been able to do: finance the full capital stack on the same commercial real estate transaction. We were able to do this for the first time last month and again this month.
I believe that this ability, to finance the full capital stack, puts RealtyMogul.com (and our investors, sponsors, and borrowers), in a favorable position in the real estate investing world, but that’s a discussion for another time. For now, let’s get back to basics and define the capital stack.
What is the capital stack?
The capital stack refers to the organization of all capital contributed to finance a real estate transaction or a company. Focusing on a real estate transaction, the capital stack defines who has the rights (and in what order) to the income and profits generated by the property throughout the hold period and upon sale. Perhaps more importantly, it defines who has rights to the actual asset in case of an uncured default.
When investing in commercial real estate through an online marketplace/platform or other means, it is important to understand the capital structure of a given transaction and the risks and rewards associated with each piece of the capital stack. Understanding the place of your investment in the capital stack is a crucial part of the due diligence process as it will help you quantify your maximum upside, and even more importantly, maximum downside.
So basically, the structure of the stack and your place within that structure determine how and when you will get paid and whether you have the ability to take control of the underlying property.
Senior Debt at the bottom…
It’s not a bad thing to be on the bottom when it comes to the capital stack. Why? Because the bottom layer is home to the most senior debt, meaning investors here are more senior to everyone above them in the stack.
So what does that mean? If the property performs well and generates cash flows that are sufficient to pay periodic debt service payments (interest and sometimes principal as well), it’s pretty simple - debt holders get their full periodic payment before any other capital contributors are paid. When the property is sold, it’s again the senior debt holders that are paid first, getting their outstanding principal and any accrued interest back.
But what happens if the property is underperforming and debt service payments are not met? In case of an uncured default, senior debt holders typically have the right to initiate a foreclosure process, take ownership of the property, and liquidate it. Once again, they will be the first in line to receive any amounts due to them once the property is sold.
Not surprisingly, senior debt investors enjoy the lowest return in the capital stack, as they have first access to cash flows and the collateral, putting them at the lowest risk in the stack.
…Equity on top
At the top of the stack are common equity holders. Common equity holders have the riskiest position in the capital structure as they are paid last. Therefore, they require a higher return to compensate them for such risk. In fact, common equity holders require the highest return in the capital stack and can potentially enjoy very high rewards. The reason for that is that they are not only entitled to receive recurring payments (although unguaranteed) from the property’s cash flows once all other capital holders are paid, but they also get a piece of the gain from the sale of the property. Essentially, unlike debt investors, equity investors gain from appreciation.
All this reward comes at a price of course: common equity holders are not guaranteed periodic payments or even their principal back. The concept of foreclosure doesn’t apply in equity. While common equity holders have rights to the property and actually own it, they pledge it as collateral and are subject to the rules of those lower in the capital stack, which puts them at a risk to lose their principal. Unless enough excess cash is available once the property is liquidated, they will not receive their full principal back. This can happen if the property’s value decreased over the hold period.
What’s in between?
Between senior debt and common equity, you will sometimes find hybrid capital instruments like mezzanine debt or preferred equity:
Mezzanine debt (“mezz”) is another form of debt, which is subordinate to senior debt and secured not by the property but by a pledge of the ownership interest (equity, which is subordinate to Mezz). Mezz debt holders enjoy foreclosure rights that are limited as they are subject to agreements with the senior debt holders. Due to the fact that mezz holders get paid only once senior debt holders are paid, they require a higher return than the senior and will sometimes participate in additional profits generated by the property on operation or upon sale.
Preferred equity (“pref”) sits between debt and common equity in the capital stack. You have probably already figured out by now – this location in the stack means that pref holders require a higher return than any debt holders, but will probably enjoy a lower return than common equity holders. Holders of pref, much like mezz, will frequently participate in any upsides on top of the periodic payment they receive.
Why should you care?
As an investor, it is important to understand your legal and economic rights with real estate investments, and how these rights change based on your investment’s performance. Understanding the structure of the capital stack and your investment’s position in it, will be an important step in getting you there.
Interested in becoming an investor at RealtyMogul.com? Start here.