Capital and financing for businesses and investments have been expanding with a wider array of options, features, and strategies.
Knowing how these types of money fit together can help investors better understand what they are getting into, the best type of debt or private equity investment to make for their own personal situation, and how operators are limiting risk and optimizing the upside with a smart capital stack.
A ‘capital stack’ just means how various types of money or financing are layered in an investment. This can include debt and equity, for different purposes. Here are some of the most common.
Senior debt is the first position debt or loan on an investment property. In real estate, this is typically in the form of a first mortgage. A loan that is collateralized by the property. The lender earns interest and installment payments. In the case of a default, they are among the first to be paid off. For investors, offering the property as collateral for this type of bank loan typically comes with lower interest rates, and enables smart leverage which lowers risk, and keeps more cash available.
This is a form of secondary or subordinate debt. This will often be seen in real estate projects involving development or renovations, which require additional capital to make improvements after the acquisition, and before the property becoming fully performing. It fills a gap in incoming cash and cash flow.
Mezzanine debt may come from alternative private equity funds. These lenders will be second in line to get paid, after senior debt in default. This debt may carry higher interest rates, and enable lenders to convert to equity if the borrower fails to pay.
Preferred equity is a type of private equity investment similar to mezzanine debt made by private equity investors. Instead of being secured by the underlying property, the sponsor offers their common equity position as collateral. They often command higher yields and are to be paid dividends and profits before common equity. This is seen as one of the safest and most profitable ways to make private equity investments.
For those entities receiving this capital, it offers additional financing, without incurring more debt or being stuck with paying interest and rigid monthly interest payments.
Common equity is like investing in a stock for regular shares. This may come with voting rights as per the agreement, and very limited liability. As this type of capital often comes in last, the project has typically already gained a lot of progress and has removed much of the risk involved. Think of this more like buying a public stock. Previous lenders and equity partners have taken the biggest risk and brought the project this far. Yields and payouts will reflect this less risky type of investment.
There are many ways to fund business ventures and real estate investments today. These are some of the main categories of financing an operator may utilize in their capital stack. Each has its own advantages for both the operator and individual investors.