Demystifying The Capital Stack

Hello Readers,

Something I regularly have conversations with investors about is how best to structure their funding as this can be a somewhat complex area. I thought I’d spend some time putting together some pointers about a very helpful model, which is a capital stack.

We all know that one of the major keys to a successful property investment is the right funding structure and the capital stack is an extremely helpful way to structure your financing that takes into account various layers of funding and can offer investors the ability to further leverage.

How A Capital Stack Is Structured

In its basic form, a capital stack in property investment refers to three concepts and rights:

  1. Tiers of financing sources such as equity and debt
  2. Order in which investors are paid back (such as through income and profit)
  3. Repayment rights should there be a default

Purchasing a house with a standard homeowners buy-to-let mortgage is probably the simplest form of capital stack. It has just two tiers with one being the mortgage lender and one being equity in the property.

An additional layer of complexity may be added should you choose to take a second charge mortgage as this will add a third tier, often with a higher interest rate to reflect the increased level of risk (as the second-tier lender will generally be repaid after the senior or first tier lender).

When structuring deals, you may have different lenders or investors who will want to have differing payment terms, rates etc and this is one of the benefits to using a capital stack model.

With a capital stack in property, you will generally have four layers. Each layer with a different level of risk and potential reward. As a rule of thumb, the investor with the higher level of risk will be in line for a higher level of reward.

You may be familiar with the capital stack illustration below where there are four main elements. This is a senior debt, mezzanine debt, preferred equity, and common equity. I’ll explain each tier below.

Common equity is the highest level of potential reward, however, also carries the greatest risk. Generally, investors in this tier will own a piece of the property and receive a share of recurring cashflow.

Common equity investors will, however, only be repaid after the debt has been serviced and investors lower down in the stack repaid.

Preferred equity functions in much the same way as a first position mortgage has priority over a second-tier mortgage.

A preferred equity investment functions in much the same way as a common equity investor (in that they receive a share of monthly cash flow and a percentage of the profits from the sale of the property), however they are paid before common equity investors.

Mezzanine debt is very similar to the position of a second-tier lender, and it is usually secured as a 2nd charge.

The mezzanine debt holds rights over the common and preferred equity; however, interest rates tend to be higher than the senior debt.

Senior debt forms the foundation for financing and will be secured against the property itself.

Because the senior debtor is secured it tends to carry the lowest risk and will therefore generally have a lower interest rate. Senior debt doesn’t have to be a mortgage and it could be a private investor or perhaps bridging lender.

The senior debtor will take priority to receive payments before all other investors in the capital stack are repaid.

The Benefits For Investors

As I outlined above, the benefits to a capital stack structure is the flexibility it provides for investors to be able to creatively structure the way they fund deals.

For example, where a senior lender may not be able to give you the LTV you are looking for and additional financing is required, a capital stack will give the flexibility you need.

Saam Lowni from Merryoaks Property Finance which serves investors and developers across the country states:

“It is important to have a broad understanding of the finance options available to you before deciding which route of finance to go for and how to build your stack.”

“Where you position yourself in the stack depends on the level of investment you find appealing, your personal financial circumstances and your appetite for risk.”
“If you are keen on being a capital provider/investor instead of a property investor/developer, it is wise to diversify your portfolio and spread your investments up and down the capital stack with numerous projects.”

“In this way, it is possible to reduce the overall risk exposure and maintain long-term appreciation.”

Do you have any questions about expanding your portfolio into the Medway towns? If so, then the best way to get in touch is via LinkedIn.


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