Capital Structure Defined (Part 1 of 3): An Overview of Debt & Equity

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Capital Structure Defined (Part 1 of 3): An Overview of Debt & Equity

By Christopher Starr

One very important element in a real estate investment is how the capital is structured.  The structure of the “capital stack” has an affect on the returns of an investment, the risk profile, and the overall success of the deal.  In this article, part 1 of 3 that define the Capital Structure of a real estate investment, we provide an overview of debt and equity.

What is Debt?

Simply, debt is a loan.  Debt is an amount of money borrowed by a person or entity from another entity such as a bank.  Debt is a loan with a requirement to repay the principal and interest by an agreed upon date in the future.  Debt is used as leverage, increasing investor returns, and commonly covers 50% to 80% of the value of an asset being purchased or refinanced.  There is Senior Debt which is the least risky and offers the lowest cost of capital, and at times subordinate debt is used, called Mezzanine Debt which has a slightly higher cost.

What is Equity?

Simply, equity is ownership.  The owners, or purchasers, of an asset, put in the capital that is the down payment.  There is Common Equity, which holds an equity interest in an entity and will receive a share of the profits at the exit, and Preferred Equity which holds a priority equity interest in an entity and will receive a preferred return and a share of the profits alongside common equity.

What is a Capital Stack?

The Capital Stack is how both debt and equity are structured together to acquire or recapitalize an asset.  This structure depends on the investor’s risk profile and the desired returns. There is a different level of risk at each level of the stack, along with a different cost of the capital.  The diagram below displays the Capital Stack in order of risk.

Conclusion

In conclusion, the capital structure of an asset is one of the most important things to consider in an investment.  By using the right amount of debt can provide the appropriate returns investors want, and can either increase or decrease the level of risk in the asset.  The capital structure is often considered during the underwriting of an asset to ensure the deal makes sense given the current cost of both debt and equity.

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Upcoming Articles:

  • Part 2 of the Capital Structure Series - The Pros & Cons of Using Debt

  • Part 3 of the Capital Structure Series - The Different Layers of Equity