What is the Order of Priority in the Real Estate Capital Stack?
The reason that capitalization matters in the structure of real estate investing is because it determines the order by which capital providers are repaid in the event of default.
In the real estate capital stack, all forms of debt are of higher seniority (i.e. higher priority in terms of repayment) than common and preferred equity.
In effect, lenders must be repaid in full before equity holders can start to recover some proceeds.
The equity holders could perhaps receive a marginal recovery on the dollar or be completely wiped out in the event of default. The latter scenario tends to be the most common.
But higher risk coincides with higher expected returns, so the upside on an equity investment is theoretically limitless (”uncapped” yield), while the returns on a debt investment are predictable, assuming all debt service payments are met on time.
Common equity is thus the riskiest, yet the most potentially rewarding layer of financing because of the uncapped upside.
From the top of the capital stack to the bottom, the risk (and thus the required rate of return) attributable to each source of capital is ranked in descending order.
Therefore, concerning the pecking order, common equity is at the highest risk of incurring capital losses in the event of default, whereas senior debt is most likely to receive a recovery in full.
In the event of default, the order of payment is as follows per the priority of the claims waterfall:
- Senior Debt → Bank Lenders
- Mezzanine Debt → Institutional Lenders (Yield-Oriented Debt Investors)
- Preferred Equity → Institutional Investors (“Hybrid”)
- Common Equity → Real Estate Investor (i.e. Down Payment)
The greater the value of the post-liquidation proceeds available for distribution to creditors, the higher the recovery rates for all parties.
However, if the liquidation proceeds are insufficient, the equity holders – namely the common equity layer – are likely to incur substantial losses.
All equity holders, common and preferred shareholders, are subordinate to the debt holders, which means the lenders must receive full recovery before equity holders can receive any piece of the proceeds – barring unusual circumstances.
How to Analyze the Capital Stack in Real Estate
Analyzing the capital stack of a real estate investment is a rather complicated task, as the operating performance of the underlying property is ultimately the determinant of the outcome.
With that said, a greater amount of debt comprising the total capitalization does not necessarily signify more risk.
Why? The property was likely capable of securing the financing in the first place, because the credit risk was deemed manageable by lenders, and the income of the property could handle the debt burden.
Most real estate lenders, especially those that provide senior debt like banks, tend to be risk-averse and prioritize capital preservation above all else.
Hence, a property funded with 80% debt must have the right credit profile to support the debt load.
On the other hand, a property funded only by 40% debt is either backed by an investor that focuses primarily on property improvements and identifying locational patterns to profit from for value creation (i.e. drive returns) or otherwise incapable of securing more debt financing.
There is no optimal capital stack for all properties per se, as sizing the loan appropriately based on the debt capacity of the borrower should be the priority.
While several external factors can determine the creditworthiness and risk of default of a borrower – such as a global recession and the Fed raising interest rates – the variables within the control of the borrower are the following:
- Stable Cash Flow Generation → The production of consistent rental income reduces the risk of default substantially, especially if the tenants of the rental property are of high creditworthiness and commercial tenants, like businesses.
- Limited Property Improvements → The fewer capital improvements necessary for a property to reach stabilization, the lower the risk profile of the real estate project. Thus, long-term developmental projects tend to be riskier, because projecting performance over periods of ten, twenty, or more years carries much uncertainty.
- Location and Market → The risk-return profile of a real estate project is influenced by trends in a specific location and market. While the long-term outlook is nearly impossible to anticipate, the near-term trends are easier to identify. Unlike products and services sold by corporations, there tend to be fewer short-term “fads” in real estate. For instance, a market in high demand for a couple of years is considered a short-term trend, while the demand can plummet for products within a matter of weeks.
How to Perform Capital Stack Ratio Analysis
Real estate lenders use several underwriting ratios to analyze the risk profile of an investment, as part of loan sizing.
But three of the more common underwriting financial metrics to estimate the debt capacity of a borrower used to set the constraint on the maximum loan amount are the following:
- Loan-to-Value Ratio (LTV)
- Debt Service Coverage Ratio (DSCR)
- Debt Yield (DY)
1. Loan to Value Ratio (LTV)
The loan-to-value ratio (LTV) measures the risk of proposed borrowing by comparing the requested loan amount to the appraised value of the property, securing the financing, i.e. the fair value of the property as of the present date.
The formula for each ratio is listed in the section below.
Loan-to-Value Ratio (LTV) = Loan Amount ÷ Appraised Property Value
The loan amount is the size of the requested financing, while the appraised property value is the estimated fair market value (FMV) of the property on the current date. Generally, the lower the LTV ratio, the less risk perceived by lenders, which is favorable to the borrower’s interests.
2. Debt Yield (DY)
The debt yield measures the riskiness of a real estate loan based on the estimated return on investment for a commercial real estate loan and represents the estimated rate of return received by a lender relative to the original loan provided to the borrower under the hypothetical scenario of default.
The formula to compute the debt yield is the ratio between the net operating income (NOI) of a property and the total loan size, expressed in percentage form.
Debt Yield (DY) = Net Operating Income (NOI) ÷ Total Loan Amount
The net operating income (NOI) of a property is the total pro forma income of a property at stabilization, inclusive of rental income and ancillary income, net of vacancy and credit losses.
Because NOI excludes non-operating items, such as financing costs and income taxes, the debt yield is effectively an unlevered, pre-tax metric.
- Lower Debt Yield (%) → Higher Credit Risk
- Higher Debt Yield (%) → Lower Credit Risk
Unique to the debt yield, the ratio is unaffected by fluctuations in interest rates, changes in the market values of properties, and the loan amortization schedule, since the total loan amount is measured.
3. Debt Service Coverage Ratio (DSCR)
The DSCR compares the net operating income (NOI) of a property to its annual debt service to determine if the income generated is sufficient to meet the annual debt burden.
Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Annual Debt Service
In the DSCR metric, the NOI of a property is divided by the annual debt service, which is the sum of a property’s mortgage payments and interest on an annualized basis.
- DSCR = 1.0x → Breakeven (NOI = Annual Debt Service)
- DSCR < 1.0x → Insufficient Income (NOI < Annual Debt Service)
- DSCR > 1.0x → Excess Income with “Cushion” (NOI > Annual Debt Service)
How to Determine the Optimal Capital Stack in Real Estate
To further expand upon the prior section, the general guidelines are usually abided by in determining the appropriate size of a commercial real estate loan by lenders:
- Loan-to-Value Ratio (LTV) → Most commercial real estate loans are capped at around 75% in most cases – i.e. the maximum LTV ratio set by lenders is 75% – in effect, the minimum equity contribution by the borrower is typically 25%.
- Debt Yield (DY) → Higher debt yields imply a higher potential return on investment on loans (and vice versa). Conceptually, the debt yield provides insights into how quickly a lender could recoup their original funds in the event of default. Each lender sets different minimum required debt yield targets, but the standard range among commercial real estate lenders is around 8% to 12%.
- Debt Service Coverage Ratio (DSCR) → Most commercial real estate lenders tend to be more risk-averse and strive to reduce the likelihood of default. Therefore, lenders often set a minimum DSCR covenant of around 1.25x to ensure the borrower is sufficient to service the debt burden, including a “cushion” to endure periods of underperformance. A DSCR ratio of 1.25x implies the NOI of the property is 125% of the total debt service, i.e. excess income of 25% to cover debt obligations.
Capital Stack Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Commercial Real Estate Property Assumptions
Suppose a commercial real estate investment firm (CRE) is currently requesting a mortgage loan from a bank lender to fund the acquisition of an office rental building.
The pro forma operating performance of the commercial property office building based on the analysis performed by the real estate investor is as follows.
| Commercial Property – Operating Performance |
|
| ($ in thousands) |
2023E |
| Gross Potential Rent (GPR) |
$2,200 |
| (+) Ancillary Income |
300 |
| Potential Gross Income (PGI) |
$2,500 |
| (–) Vacancy and Credit Losses (@ 6.0%) |
(150) |
| Effective Gross Income (EGI) |
$2,350 |
| (–) Total Operating Expenses |
(1850) |
| Net Operating Income (NOI) |
$500 |
On the topic of the purchase price, the market cap rate is 8.0% – which we can divide the property’s NOI by to estimate the property value.
Purchase Price
- Net Operating Income (NOI) = $500k
- Market Cap Rate (%) = 8.0%
- Property Value = $500k ÷ $8.0% = $6.25 million
So the question now becomes, “How will the property purchase be funded?”
2. Capital Stack Calculation Example
For simplicity, we’ll assume there is only one source of debt, a commercial real estate loan, with the remaining purchase price contributed by the commercial real estate investment firm (CRE).
The size of the loan requested by the real estate investor is $4 million, with a term of 30 years.
Commercial Real Estate Loan
- Commercial Loan Size = $4 million
- Annual Interest Rate (%) = 6.0%
- Loan Term = 30 Years
Based on the risk profile of the proposed borrower and real estate project, the interest rate attached is 6.0%.
Since the size of the commercial loan was provided, the equity contribution – i.e. the down payment to “plug” the remaining financing required – from the real estate investor is the difference between the purchase price and the total loan amount.
Equity Contribution
- Purchase Price = $6.25 million
- Total Debt Balance = $4 million
- Equity Contribution (“Down Payment”) = $6.25 million – $4 million = $2.25 million
3. Capital Stack Loan Sizing Ratio Analysis
Given the debt and equity components used to fund the purchase, we can determine the percent contributions per capital source by dividing each by the total capitalization.
Capital Stack
- Total Capitalization = $4 million + $2.25 million = $6.25 million
- % Debt Contribution = $4 million ÷ $6.25 million = 64.0%
- % Equity Contribution = $2.25 million ÷ $6.25 million = 36.0%
While not too practical in our scenario, it is recommended to compute the sum of the debt and equity percent contributions to ensure the total is 1 (or 100%), as a quick “sanity check”.
- % Total Capitalization = 64.0% + 36.0% = 100.0%
In the final section of our modeling exercise, we’ll measure the risk attributable to the financing by applying the risk ratio concepts mentioned earlier.
Loan Sizing Ratio Analysis
- Loan-to-Value Ratio (LTV) = $4 million ÷ $6.25 million = 64.0%
- Debt Yield (DY) = $500k ÷ $4 million = 12.5%
- Debt Service Coverage Ratio (DSCR) = $500k ÷ PMT(6.0%, 30 Years, $4 million) = 1.72x
If we assume the lender sets the parameters of a maximum 75% loan-to-value (LTV) ratio, a minimum debt yield of 10.0%, and a minimum debt service coverage ratio (DSCR) of 1.25x, the capital stack of the proposed commercial lending is likely to receive approval.
