The Capital Stack in Real Estate Private Equity // Big real estate deals generally aren’t funded with only cash from one investor, and most commercial real estate purchases have several layers of capital that fund the deal, known as the capital stack in real estate. But what makes up the capital stack in real estate, and how does the real estate capital stack work? That’s what we cover in this video.
Hey this is justin from break into crüe calm and in today’s video we’re gonna break down the real estate capital stack so if you’ve been curious as to how big commercial real estate deals actually come together and are actually financed make sure to stick around for this video now if you’re new here on this channel we talk about real estate investing careers
And real estate finance and financial modeling so if you’re looking to break them in the industry or advance your current career make sure to subscribe and hit the notification bell now the real estate capital stack really represents the different sources of capital that come together to finance a real estate investment deal commercial real estate deals can be huge
Amounts in total and so most investors don’t want to fund eight or nine figure deals on just cash alone so in this video what we’re going to do is break down the real estate capital stack and the different components that make up a real estate transaction now an easy way to start off thinking about this is by thinking of the capital stack as just a bar graph and
This bar graph is going to take into account all of the costs to capitalize the project now the capital stack is really just that bar graph broken down into chunks and each chunk is a different source of capital that’s used to capitalize the project now the easiest way to walk through this is through an example so let’s say for example you buy a property for ten
Million dollars now if you were to buy that property with 100 percent cash that bar graph would all represent that cash that you use to purchase the deal now usually in commercial real estate you’ll have some sort of loan on the property specifically senior debt where that lender is in first position to foreclose in case anything happens on the deal now usually the
Senior debt is somewhere between 50 and 75 percent of the overall purchase price of the deal which reduces your cash commitment and adds another chunk to that bar graph so in this example let’s say we have seven million dollars of loan proceeds for 70 percent loan to value ratio so now with 7 million of the required 10 million dollars to capitalize the project an
Investor may choose to add an additional layer of debt to the property or some sort of junior debt on that property now this debt will usually be subordinate to that senior loan meaning that the senior loan must be repaid first before the junior lender gets paid back at all so sometimes you might hear this referred to as mezzanine financing so let’s assume we have
1 million dollars of mezzanine financing here for total of eight million dollars so far of that 10 million dollar requirements so at this point of the capital stack you usually funded all of your debt and now you can move into the equity portion of your capitalisation now the next layer in the capital stack that you might see on the equity side is called preferred
Equity and preferred equity is subordinate to the senior loan and the junior loan meaning that the senior lender and the junior lender both get paid back first and have first priority to be paid back first on a sale but with that said preferred equity is senior to any sort of common equity sources so essentially what that means is that the common equity is putting
Up that equity as collateral so if for any reason the property is sold and all equity sources can’t be repaid the sale proceeds will go to preferred equity first before any sort of common equity preferred equity sources will also often participate in some sort of upside in case the property performs well so let’s say we have an additional $1,000,000 of preferred
Equity on this deal for a total capitalization at this point of nine million of the ten million dollars and at this point we only have one million dollars of remaining capitals of fun and that’s where that common equity comes into play now common equity is usually made up of two different parts the first is the equity from the gp or general partner on the deal
So this is the operating partner or the sponsor that’s actually putting the deal together and that is going to operate the property on a day to day basis then you’ll also have the limited partner or lp which is going to be the capital partner providing funds on the deal but the partner that’s not actually doing any of the operations now usually what you’ll see is
That the general partner will fund somewhere between one and ten percent of the overall common equity requirement and the limited partner will fund the remaining ninety to ninety nine percent so in this case let’s assume the limited partner contributes ninety-five percent of that equity requirement or nine hundred and fifty thousand dollars and the general partner
Contributes fifty thousand dollars or five percent of that total common equity requirement and from there we have our full ten million dollar capitalization in our capital stack is complete so you can see we have several different layers but the capital stack is really just the different capital sources that make up the total capitalization of a deal now this is
An interesting example because it shows how a single investor or single private equity firm can invest as little as 50 thousand dollars can control a 10 million dollar asset so that’s the power of the capital stack adding different sources of capital with debt and equity and putting all of that together to capitalize a real estate deal also as you can see the risk
Of the investor goes up as you move up the capital stack so while the senior lender takes on the least amount of risk the return to that senior lender is the lowest and while the common equity investor takes on the most amount of risk that return to that common equity investor is generally the highest so while a borrower may be able to secure an acquisition loan
At a 4% interest rate junior debt might be closer to 8 percent and then preferred equity might be closer to 12 percent and then the limited partner common equity investors will participate in the profits of the deal and require some sort of hurdle rate to be hit before the general partner receives any sort of outsized profits or promoted interest on the deal so
At the end of the day when you hear someone talking about the real estate capital stack it really just comes down to the different ways that a property is capitalized between debt and equity sources so i hope that was helpful if you like this video and want to see more content like this make sure to let me know by hitting that like button subscribe to the channel
And share this with anyone else who might find this helpful thanks so much for watching and i’ll see you in the next video you
Transcribed from video
The Capital Stack in Real Estate Private Equity By Break Into CRE
