If you’re looking for funding for your Multifamily business, you’ll need to know about the capital stack. This term refers to the various sources of capital that a real estate operator can use to finance its operations. It’s important to understand capital stacks because different sources of capital come with different risks and rewards. In this article, we discuss what capital stack is and how to use it to finance your business.
What is Capital Stack?
The capital stack is the capital structure of a business. It’s a term often used in commercial real estate investment to describe the various sources of capital that are available for financing projects or companies. The capital stack can include equity, debt, and mezzanine financing from different investors. In other words, capital stack describes how much money each investor has invested into your company at any given time. Each capital source comes with its own risks and rewards as well as different levels of seniority (i.e., which one gets paid first if there is a default).
What Types of Capital Are There?
There are four types of capital: equity, preferred equity, senior debt, and junior debt. Equity represents ownership rights in an entity. Preferred equity investors have preferential rights over dividends and the liquidation of assets; senior debt is a loan with repayment priority ahead of other creditors, and junior debt is a loan with lower repayment priority than senior debt.
Equity: Benefits and Drawbacks
Equity capital is the most common form of capital for businesses. It gives investors ownership rights in an entity, which means they can participate in any profits or losses. Equity capital also provides holders with voting rights on important business matters and may include some restrictions, such as a prohibition against selling their shares without agreement from other shareholders (for example, if you issue restricted stock to your employees).
Advantages:
You don’t need to pay back equity capital – only give up some control over your company’s direction and future growth potential. This makes it easier to raise money because there is lower risk involved than when raising debt financing (where creditors expect repayment plus interest).
Disadvantage:
Giving away too much ownership can mean that you lose control of your company and its future direction.
Preferred Stock: Benefits and Drawbacks
Like equity, preferred stock gives investors ownership rights in an entity. However, holders of preferred stock have preferential rights over dividends and the liquidation of assets, meaning they get paid before common equity shareholders if the company is liquidated or pays out dividends. Preferred stock also typically has a higher priority than debt capital when it comes to repayment in the event of bankruptcy.
Advantages:
Preferred shareholders typically receive a fixed dividend payment each year (regardless of how well the company is doing).
They are also first in line for repayment if the company goes bankrupt, making them a lower risk for creditors than common equity shareholders.
Disadvantage:
Preferred stockholders typically don’t have voting rights, which means that they can’t make decisions about the company’s future.
Senior Debt: Benefits and Drawbacks
Senior debt is a loan with repayment priority ahead of other creditors. In the event of bankruptcy, senior debt holders are first in line to be repaid their capital plus interest, making them less risky for investors than junior debt or equity investors. Senior debt also comes with more favorable terms, such as a lower interest rate and longer maturities.
Advantages:
Senior debt is a relatively low risk because it has the highest repayment priority if the company goes bankrupt.
It also comes with more favorable terms such as a lower interest rate and longer maturities.
Disadvantage:
Senior debt holders don’t get a higher return if the company does well – they get paid back their capital plus interest, regardless of how profitable it is.
Junior Debt: Benefits and Drawbacks
Junior debt is a loan that has lower repayment priority than senior debt but higher than equity investors in the event of bankruptcy. As such, junior debt holders are at higher risk for losses if an economic downturn or other unforeseen events lead to liquidation (although this usually doesn’t happen).
They also tend to have less favorable terms, like shorter maturities and higher interest rates, making them more expensive over time compared with senior loans because there is a higher chance of them not being repaid in full.
Advantages:
Junior debt holders get paid back before equity investors if the company goes bankrupt, making them less risky for investors.
They also tend to have more favorable terms like shorter maturities and higher interest rates than senior debt, making them cheaper over time.
Disadvantage:
Junior debt holders are at higher risk for losses if an economic downturn or other unforeseen events leads to liquidation.
How Is Capital Stack Used?
People use capital stack in different ways to finance a business. One option is to raise capital for new investments or acquisitions. Another option is to use it as a way to refinance existing debt. Finally, you can also use capital stack to pay out dividends or repurchase shares from investors.
Funding Real Estate Investment Through Capital Stack
Funding commercial real estate investing through a capital stack is extremely popular because it provides investors with a low-cost alternative to traditional capital sources such as bank loans or private equity financing. Capital stack is an effective way for real estate developers to finance their projects. It allows them to access capital at lower costs than conventional financing options, like a bank or other mortgage lender, might offer (e.g., if they have poor credit).
Refinancing Through Capital Stack
Another popular use of capital stacks is refinancing existing debt, which is done in several ways. One example is issuing new shares and using the proceeds to pay off old stockholders’ stakes. Another option would involve repurchasing outstanding bonds by offering more favorable terms on new ones issued instead (for instance, changing interest rates from fixed-rate mortgages into adjustable-rate mortgages).
Paying Out Dividends and Repurchasing Shares
One final way to use capital stacks is to pay out dividends or repurchase shares from investors. By doing this, a company can return capital to its shareholders while reducing the number of outstanding shares, increasing the value of each remaining share. Companies often prefer this approach over issuing new debt or equity. It doesn’t increase their overall leverage (the amount of debt relative to equity) and can improve their credit rating.
Why Is Capital Stack Important?
Capital stack is important because it determines how much money each investor has invested into your company at any given time. This affects their level of risk and reward as well as their priority in the event of a default. It’s important to understand capital stacks and their implications for your business so you can make informed decisions about how to finance your operations.
