One of the benefits of investing in commercial real estate is the diversity of opportunities within the sector. Diversity can be achieved by investing in a variety of strategies (e.g., debt vs. equity or stable assets vs. opportunistic), property types, geographic regions or levels of risk.
One common way to balance risk is to invest in different parts of the “capital stack,” which refers to the various layers of equity and debt through which commercial properties are often capitalized. The different parts of the stack are called “tranches,” which are essentially horizontal slices of risk in the vertical capital stack. On a continuum of risk-reward, from high-risk and higher-return to low-risk and lower-return, the capital stack is:
Common Equity: Also referred to simply as Equity, this is a pure ownership stake in an asset. It ranges from 80% to 100% of the capital stack and is the riskiest tranche. Equity is last in line to receive the remaining cash flow distributions, but gets the “upside” and a larger share of the sales proceeds at exit to compensate for the risk.
Preferred Equity: Typically from 75% to 95% of the capital stack. Holders receive a regular dividend and a limited share of profits. They have a direct ownership stake in the property with the equity holder and share the equity risk with, but are senior to, the Equity holder.
Mezzanine Debt: In effect a junior loan to the senior mortgage within the range of 50% to 80% of the capital stack, holders are paid a dividend that is greater than the senior loan. They have a pledge of an ownership stake in all of the equity of the collateral property’s ownership entity which they can claim in the event of default.
Senior Debt: Typically from 0% to 50-65% of the capital stack. First mortgage holders get paid a dividend that is lower than subordinate capital sources and also have the right to foreclose in the event of a default (i.e., seize the title and takeover the ownership).
It should be noted that not all properties need each component – some can be owned with all equity, and some might be capitalized with only equity and senior debt. That said, how does the capital stack work in practice? Let’s assume a $10 million property that is capitalized by a:
- $5.0 million senior mortgage with a 5% coupon.
- $2.0 million mezzanine loan pegged to Libor plus 750 basis points (approximately 7.7% as of mid-year 2015).
- $1.5 million preferred equity stake that pays an overall yield of 15%, with a 9% current pay coupon and a 6% accrued coupon (paid at maturity) and $1.5 million of equity. As tenants pay rents, the income is distributed in reverse order of the capital stack. The senior lender is paid first, then the mezzanine lender and the preferred equity holder. Whatever cash flow left over is profit for the equity holder (and possibly the preferred equity holder).
Participating in different parts of the capital stack enables investors to build a portfolio that contains a blend of risk and returns. Low-risk assets have lower returns, while assets with more risk have higher returns. The mid-risk assets of mezzanine debt and preferred equity are typically structured to provide attractive higher yields that are superior to the relative risk.
These middle tranches are designed to remain “money-good” (i.e., no loss of principal) even if the equity investment tranche doesn’t perform as underwritten. By investing in multiple assets with a blend of risk-return characteristics, investors can build a portfolio that caters to their specific return needs and risk tolerance.