not a menu item, though I could envision a whopper be named after it. But personally I like the imagery of a layered cake much more…Yum!
In financial parlance, Capital Stack (aka Capital Structure) is simply the aggregation of every type of funding – common equity, preferred equity, mezzanine and senior debts, that goes into the purchase, improvement or development of a particular project or asset. Yes, that’s all there is to it. In corporate finance, there are many more layers of stacks or complex structure (e.g. senior secured, senior unsecured, etc) but for now, the major breakdown between debt and equity more than suffices.
As seen in the diagram below, the right column forms the “Sources of funds” which are raised or sourced for the left column “Uses of Funds”, namely to purchase the Assets. Ultimately, the goal is to grow the value of the Assets on the left, so that, on the right, as the size of Debt is fixed (assuming it doesn’t negatively amortize), Equity grows.
A = L + E; if A increases, (L + E) increases; if L = constant, E has to increase. Got it?
Debt and Equity have vastly different risk and return profiles, so understanding the differences is crucial in investing.
Debt: When you invest in debt, you make a loan to the borrower. In return for the use of your money, the borrower pays you back the original loan, the principal, plus interest for the use of your money. Some examples of debt investments are mortgages, bridge loans and hard money loans. The contract to repay a debt is called a promissory note; which is why some people call debt investing: “note investing”.
You can loan money for short-term (a few months to a year) or make longer term loans lasting years or decades (e.g. in the case of Seller Financing when you are the Seller). Payment terms might require the borrower to pay both interest and principal on every payment (like an amortizing mortgages). Others (e.g. hard money loans) are typically interest-only (in this case non-amortizing, meaning that the borrower pays only interest on the payments, which doesn’t reduce the principal), and then pays the entire principal back on the final payment when the loan comes due.
Equity: When you invest in equity, you are a part owner of the property and get to share in the profits. These profits come from rental income and/or property price appreciation. (Conversely, if the property is not run profitably or depreciate in value, there would be no income and the equity can be wiped out completely.)
Often equity investment returns are structured to split the profits between you and the sponsor based on certain performance. We will go into detail in another post. It’s important that you understand how the split works and feel comfortable that it is protecting you as an investor and is not overly generous to the sponsor.
So what’s the difference?
In general, debt is safer than equity on that same investment. This is because if something goes wrong, and the property is foreclosed and sold, the debtholders get paid first. In a liquidation situation like this, equity holders often have no recourse. Even in situations where they do, they’re still in a much higher risk of taking losses or completely being wiped out then a debt investor in the same project.
The flip side of this is that since debt is usually safer it has a lower return than equity. Also, debt investments have no upside potential, while equity does. If a real estate project is wildly successful the debt investors do not get to participate in the windfall and are limited to simply getting the agreed-upon interest rate and return of principal. However, the equity investors do get to participate in the upside.
Not all real estate projects have the complete stack. For example, a hard money loan investment is just the senior debt portion and usually has no other types of debt or equity involved. Other projects might have an even more complex stack than the one shown in the picture.
No matter what the structure, it’s important that you, as investor, fully understand what it is in the project your investment is in and where in the capital structure/ stack your particular investment falls, and what that means to the risk and reward. Once you know that, you can gauge if the investment meets your investment criteria and goals, or not.