How Commercial Real Estate Deals Are Funded (The Capital Stack)

Because of the extremely high price point of most commercial properties, unlike dollar-cost averaging into something like an index fund (or even buying a single-family home to rent out), it can be extremely difficult to make these investments completely by yourself.

This is why most commercial real estate deals are funded with multiple different capital sources, and these funding sources are what are referred to in this industry as the “capital stack”.

And in this post, we’ll break down how commercial real estate deals are typically funded, how each layer of the capital stack ends up working together, and some things you’ll need to consider if you’re weighing different funding options.

Watch the Full Video Here:

Understanding the Capital Stack

I think the simplest way to explain this is by using a sample deal scenario. Let’s say an investor identifies a property that’s a great deal, but between the purchase price and all costs associated with the transaction, the total acquisition cost would be $10 million.

Let’s also say that this investor is an individual with experience in commercial real estate, and they know they can add value to the property, but they personally only have $100,000 in savings that they could use to put towards the deal.

In this scenario, if this investor wants to pursue this acquisition, the first thing they’re likely to do is look for what’s often the cheapest form of capital from an interest rate perspective, and this is senior debt.

Senior Debt (The Foundation)

Senior debt refers to loan proceeds that are typically funded by a bank, insurance company, or agency lender, that will usually make up anywhere from about 50% to 70% of the cost to acquire a property. The “senior” portion of the term “senior debt” refers to this lender having payment priority over other investors in the deal.

How Senior Debt Works

When this investor uses senior debt, the cash flow their property will generate will first be used to pay the monthly debt service associated with this loan. If the investor can’t pay that monthly debt service and defaults, this senior lender could take back the property.

This also means that when the property is sold, this lender is going to be owed their entire outstanding loan balance at that time, before the equity investor takes home anything. And if the value of the property itself has decreased to the point where it’s worth less than the value of the loan at this time, that investor’s equity position would be wiped out completely.

In this case, let’s say this investor is able to find a lender that’s willing to fund 65% of the acquisition costs, or $6.5 million. This is a huge step in the right direction, but still leaves a gap of $3.5 million to finance the deal.

Common Equity (GP and LP Partnership)

Since this investor only has $100,000 to contribute, the next thing they might do to fund this transaction is raise capital from equity partners.

Creating a Partnership Structure

To do this, the investor who identified the property would typically create a partnership where they would act as the active general partner (GP) and manage the property on behalf of other investors. From there, they would go out and raise capital from passive, limited partners (LPs) that wouldn’t be involved with the day-to-day operations of the deal.

Together, these investors would be considered common equity investors, again with that senior lender having payment priority above both the general and limited partners on a deal.

The GP/LP Split

In most cases, when a partnership is formed, a GP will fund approximately 5%-10% of the total equity requirement. This is done primarily to make sure potential limited partners know they have a vested interest in the success of the investment, and from there, the GP will look for the remaining 90%-95% of equity required to come from their LPs.

In this case, let’s say that the GP investor buying this $10 million property has a huge network of both industry professionals and high net worth individuals, and they’d easily be able to raise 95% of the equity requirement, or $3.325 million. This leaves just $175,000 remaining to fund this transaction.

However, even though this is significantly less than that initial $3.5 million amount, with only $100,000, this investor is still going to come up short on funds. In cases like these, investors will often look for another layer of financing to make up the difference, and from here, this is usually mezzanine debt.

Mezzanine Debt

Mezzanine debt refers to an additional layer of debt financing, with this lender being in second position behind the senior lender on the deal.

Why Mezzanine Debt Is More Expensive

Senior lenders will often have the right to approve or deny the use of mezzanine debt on a transaction, because this incorporates additional monthly debt service obligations that ultimately increase the borrower’s risk of default.

Mezzanine debt also usually comes along with much higher interest rates than you would see on a senior loan, because these lenders are taking on a higher level of risk. And in large part because of this inherent risk, mezzanine lenders are also usually only going to be willing to fund a very small percentage of the overall capital requirements of a deal.

Mezzanine loans can often take a borrower’s total loan-to-value ratio up to something like 75% or 80%, which reduces the total equity the GP needs to raise, but this also comes with the reality of much tighter cash flows and less room for error.

Applying This to Our Example

To apply this to our sample deal scenario, let’s say that the senior lender signed off on a mezzanine lender funding 10% of the total capital requirements, or $1 million. This brings the equity requirement down to just $2.5 million, and only $125,000 that now needs to come from the GP.

However, this is still more than what that GP has available to contribute.

Preferred Equity

To make up the difference here, investors will sometimes move on to an even more expensive capital source that often acts as a hybrid between debt and equity financing, and this is preferred equity.

How Preferred Equity Works

Preferred equity investors will have payment priority above common equity investors, but they’ll be behind both the senior lender and the mezzanine lender in payment priority. Preferred equity payments are often structured as a mix of:

• Current pay, which essentially acts as a regular monthly payment
• Accrued pay, which builds up over time and is owed when the property is sold

These two forms of payment can often lead to all-in preferred equity rates in the 15%-20% range for preferred equity capital, which is why this is rarely used by investors unless absolutely necessary.

Final Piece of the Puzzle

In this case, this investor just doesn’t have access to an additional $25,000, and a preferred equity provider that could contribute another 10% of the capital requirement would finally bring that GP’s required equity contribution down below that $100,000 mark (to just $75,000).

The Complete Capital Stack

Between multiple different capital sources, this investor is heavily leveraged and taking on a significant amount of risk to fund this deal. However, this is a prime example of how individuals can end up controlling a $10 million asset with very little capital out of their own pocket. This same concept scales up to $50 million deals, $100 million deals, or billion-dollar portfolios acquired by private equity firms.

When you hear the term “the real estate capital stack,” this is essentially just referring to the different capital sources that are used to fund a deal and the payment priority of each of those sources.

How To Learn More

If you want to learn more about each of these capital sources, and how to model things like GP and LP cash flows, mezzanine debt structures, and preferred equity structures in Excel, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.