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The capital stack represents the totality of all the various financial entities that are part of and support the project. It contains all the financial variables that provide the instrument, e.g. Acquisition of land for development, financing of horizontal and vertical development of Planned Unit Development (PUD), recapitalization of structure to accommodate buy-in of partners, etc. Covers various capital components. At different levels of the risk/reward spectrum and in the event of default or projected unrealistic returns, there is a need for appropriate compensation for risk in the structure. Availability of capital is critical to the viability of financing commercial real estate projects. It represents the organic and inorganic growth life of the property portfolio, the ability to capture deal flow and numerous financial maneuvers to strengthen the principal’s balance sheet. CRE operations require capital in its various forms and are essential to the strength of the asset’s financial structure. Generally, most real estate transactions are financed with a combination of debt and equity in various permutations.
Senior Debt – This is a first debt instrument that has a priority lien of senior to subsequent liens in order of record. Other liens junior in status may be wiped out if there is insufficient equity in the capital structure after the first lien holder is compensated if the foreclosure approaches based on the value of the defaulted collateral. A first mortgage can be considered the basic capital in the financing structure upon which other capital is added to the mix as needed to complete the stack. This capital may include most of the capital required to carry out the transaction by adding the sponsor’s equity to meet the total amount required.
Junior Debt – This is a second, third or other junior debt instrument to which the affected property is subordinated by lien status, recordation order or subordination. A junior lien is considered a risky loan from the creditor’s perspective on a property because of the priority of the lien, and a foreclosure potentially leaves insufficient equity in the property to satisfy the debt beyond the first lien holder thereby extinguishing the rights of all junior lien holders. . Junior lien holders require higher than usual interest rates and risk premiums through shorter durations to justify assuming the higher risk inherent in the loan; The return on investment (ROI) required by junior liens must be greater than the risk lien position in the capital structure. Junior debt instruments can increase the loan-to-value (LTV) on a property through an additional lien applied to the property.
Mezzanine Capital – A hybrid financial instrument that can act as equity or debt that fills gaps in the capital structure of commercial real estate and occupies a position above senior and sometimes junior debt instruments. Sometimes if there is a shortfall in collective debt financing or if there is a disparity between the equity positions of property investors and collective debt instruments, mezzanine capital is used to bridge the gap. The fund is arranged to provide its provider with an associated risk premium to compensate for the level of risk of principal and unrealized returns. Unlike senior and junior debt instruments, mezzanine debt is usually not collateralized against the underlying real estate used in the financing when structured as preferred equity, and is collateralized against assets when issued as debt and used to increase the loan to value (LTV) on the debt financing. As a junior lien.
Preferred Equity – This is an equity contribution in which the source gets a preferred return on their money at an agreed coupon rate before the sponsor gets the promotion; Percentage of profit. It reflects the position preferred equity occupies in the capital structure, the risks associated with that position, and the associated compensation required to occupy that position. This capital bridges the gap between the sponsor’s equity and other financing and reduces the sponsor’s equity risk in the project. Using preferred equity in combination with other components of the capital stack increases leverage and can also increase return on investment (ROI) when structured judiciously; It represents a viable means of using outside equity in real estate transactions to reduce capital risk and forgo some of the transaction’s upside.
Sponsor Equity – This is the cash contribution, accumulated market value in excess of other capital structure components for the asset or value in other assets owned by the sponsor eligible for cross-collateralization. In its simplest form, it is the customary down payment required by lenders. from borrowers in excess of the loan amount provided for purchase. Sponsor equity can be created due to asset appreciation and/or loan principal reduction. This creates equity in the assets which the sponsor can leverage for portfolio pyramiding, capital improvements etc. This equity represents the sponsor’s capital at risk of property depreciation, foreclosure, etc. There is a possibility of contraction. Sponsors try to reduce their risk exposure by using other financial instruments available in the capital structure and risk their cash outlay or equity while at the same time using leverage to increase cash on cash income.
When financing commercial real estate, not all components of the capital stock are necessarily used. However, they are possible options that can help principals achieve their goals. How the contract is structured depends on the parties involved and their objectives, financial markets and assets. However, maintaining flexibility and being aware of available variables that can be used increases an investor’s tool kit and propensity to be effective in completing transactions.
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