The Capital Stack Pyramid: Priorities, Risks and Returns
In this episode of "Property Pointers: Real Estate Law Simplified," Real Estate attorney Zach Brenner introduces the basics of real estate capital stacks. He explains how the stack functions like a pyramid, outlining the priority, risk and return at each level. The episode covers senior debt, mezzanine lending and equity financing, including the differences between preferred equity and common equity. Mr. Brenner highlights how understanding the capital stack helps advisors and clients see where money comes from and where it goes in a transaction.
Zach Brenner: My name is Zach Brenner, and I'm an associate at Holland & Knight. Today I'm going to give a brief introduction to capital stacks. Now, if you work in the real estate finance space, this is important because you can accurately advise your client on where their money is coming from or where their money is going.
The capital stack can be thought of as a pyramid, each level having a different level of priority in the context of a loan. The first level of the pyramid is senior debt. Senior debt is often provided by a commercial bank, and it offers the lowest return, because it has the lowest risk. If the borrower defaults, the lender will take possession of the asset.
Going down one level, we have mezzanine lending. In this scenario, instead of the loan being provided directly to the entity holding the property, it is provided to the 100 percent parent of the property owner entity. Then, the borrower's ownership interests in the property owner are pledged as the lender's security in the form of a pledge and security agreement and UCC filing. If the lender forecloses, the lender becomes the 100 percent owner of the property owner and, accordingly, the 100 percent indirect owner of the property.
The next two levels are both equity financing. Equity financing has a higher risk than debt financing, but a much higher upside. Equity financing can be divided between preferred equity and common equity. Preferred equity investors receive their minimum return before common equity investors. Common equity investors are paid after all parties in the capital stack receive their entitled funds but have the right to all income left after everyone gets paid.
Of course, there's much more detail at each level, so if you need more information contact a Holland & Knight attorney.