Capital Stack 101 – Debt vs Equity
For real estate investors it is vital to understand the “capital stack” to assess risk. The term refers to the different financial sourcing layers that go into funding real estate investments. The capital stack provides investors with useful information about where they come in the pecking order of cash flow, and what the order means for their repayment. While there’s no specific limit on the number of layers a capital stack contains, this article will look at the two most common: preferred equity and senior debt.
Explaining Preferred Equity
Preferred equity is one of the most profitable, but riskiest options for real estate deals. Investor risk in equity is significant because every other type of capital comes before the equity holder. In other words, those holding equity get paid last. However, if the property is successful, investors may have no cap on their potential returns. This means that a successful equity project can be very lucrative.
Senior debt is secured by the deed of trust or mortgage on the property itself. This means that if the borrower fails to pay the amount owed, the lender can take ownership of the title to the property. This makes senior debt one of the least risky investments available in real estate. However, the low risk means that returns are limited too. Senior debt investors expect a lower yield on their investment compared to equity investors in exchange for a more secure position.
Understanding the different debt structures available for real estate investors, and how they work in the capital stack is crucial for investors who want to make the most out of their portfolio. Similar to investing in bonds or stocks, the risks and returns of different debt investment options will determine an individual’s diversification strategy according to their investment goals.