New on FinoLib · Volume III: Finance Encyclopedia
My latest article is now live on FinoLib, the free finance library I write: Capital Stack Explained: How Real Estate Deals Are Financed, from Volume III: Finance Encyclopedia. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
The idea in plain words
A property deal is paid for in layers called the capital stack: senior debt, mezzanine debt, preferred equity and common equity. Each layer is paid in full before the next gets anything, like water filling a tower of glasses from the top. A layer’s risk depends on its attachment point: how far the property’s value can fall before that layer starts losing money. Leverage changes the return on the owner’s equity, not the return on the building.
Key points
■In a $50M deal with 20% common equity, a 10% fall in value costs the sponsor half its money while the senior lender loses nothing.
■Preferred equity is wiped out at a 25% fall in that deal, despite its fixed coupon.
■Leverage adds to equity returns only while the cap rate exceeds the loan rate; otherwise it is negative leverage.
■A 20% promote over an 8% preferred return gave the sponsor a 24.2% IRR and investors 13.6% on a deal earning 14.9%.
A closer look
A real estate or infrastructure asset is almost never financed by a single source of capital — it is built from layered claims called the capital stack, ranked by priority of repayment, echoing the capital structure concepts from Capital Markets Part 1 but applied specifically to a single physical asset rather than an entire operating company.
A worked example
Worked Example — Levered vs Unlevered Return
Leverage changes the return on equity, not on the building. The unlevered return is NOI plus the change in value, divided by price; the levered return follows Modigliani–Miller’s second proposition (Capital Markets §1.6): unlevered return + (unlevered return − cost of debt) × debt ÷ equity. Buy the $50M building at a 6.5% cap rate (NOI $3.25M; cap rates are explained in Section 2.2: Cap Rates and Property Valuation) with $32.5M of interest-only debt at 6.0% (interest $1.95M) and $17.5M of equity; sell after one year. Sale at $52M: unlevered = ($3.25M + $2.0M) ÷ $50M = 10.5%; levered = ($3.25M − $1.95M + $2.0M) ÷ $17.5M = 18.9%. Check: 10.5% + (10.5% − 6.0%) × 1.857 = 18.9%.
Under the hood
Under the Hood: Why the Promote Makes the Sponsor’s Payoff Convex
Common equity is usually split between a sponsor (the general partner, GP), which runs the deal with a small stake, and investors (limited partners, LPs). A distribution waterfall pays capital back, then a preferred return, then gives the sponsor a disproportionate share of the rest, the promote, the real estate cousin of carried interest (Capital Markets §2.8). Illustrative: $20M of equity (LPs $18M, GP $2M), an 8% compounding preferred return, then 80% pro rata and 20% promote; one exit after five years for $40M. Tier 1 returns $20.00M of capital. Tier 2 pays $20M × (1.08^5 − 1) = $9.39M.
Decision rule
Before buying into any layer, compute its attachment and detachment points (the falls in value at which it starts losing and is wiped out). If you lend senior, the layers beneath you should cover at least the fall this property type suffered in its last serious downturn; price mezzanine or preferred equity attaching below about a 25% fall as equity risk with a capped upside. These are heuristics, weaker for long leases to investment-grade tenants.
The costliest mistake
Treating preferred equity or mezzanine as “debt-like” because it pays a fixed coupon. In the $50M example, a 30% fall wipes out the whole $2.5M preferred layer and half the $5.0M mezzanine while the senior lender loses nothing: a fixed coupon with an equity-sized loss. Price each layer on its attachment point, not its coupon.
Why It Matters
The capital stack’s strict repayment priority is precisely what allows a single property to attract capital from investors with completely different risk appetites simultaneously — a conservative pension fund can hold the senior debt for a modest, secure return, while a real estate developer holds the common equity, accepting far more risk for the chance at outsized returns from the exact same building.
Recap
The capital stack ranks senior debt, mezzanine debt, preferred equity and common equity by repayment priority, and each layer’s risk is set by its attachment point rather than its coupon: in the $50M example common equity is wiped out at a 20% fall and preferred equity at 25%.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Capital Stack Explained: How Real Estate Deals Are Financed, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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