Senior Debt Subordinated Debt Structured Finance And Foreign Currency Options Capital Stack

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Capital Stack

The capital stack represents the totality of all the various financial components that are part of and support the project’s capital structure. It has all the financial variables that make it available, for example acquiring land for development, financing the horizontal and vertical development of planned unit development (PUD), recapitalizing the structure to accommodate the purchase of partners, etc. At different levels of the risk/reward spectrum and in the event of default or projected unrealized returns, commensurate compensation is required for the position at risk in the structure. Availability of capital is critical to the viability of financing commercial real estate projects. It represents the life of organic and inorganic growth of the asset portfolio, the ability to capture deal flow and a myriad of financial moves to strengthen the principal’s balance sheet. Capital in its various forms is essential for the operation of CRE and it is essential for the soundness of the financial structure of the property. Generally, most real estate transactions are financed with a combination of debt and equity in various configurations.

Senior Debt – A first debt instrument that has priority over another lien senior in order of record. If foreclosure is imminent based on the value of the underlying collateral, other liens in the position can be wiped out if there is insufficient equity in the capital structure after the first lien holder is compensated. The first mortgage can be considered the basic capital in the financial structure with other capital added to the mix as needed to complete the stack. This capital may comprise the majority of the capital required to operate the transaction by adding the sponsor’s equity to meet the total amount required.

Junior Debt – A second, third or other junior debt instrument that affects property junior through lien status, record sequence or subordination. A junior lien is considered a risky loan from the lender’s point of view due to the priority of the lien on the property and in the event of foreclosure there is potentially insufficient equity remaining in the property to satisfy the loan, eliminating the rights of all junior lien holders of the first lien holder. . Junior lien holders require a risk premium quantified through higher interest rates and shorter durations to justify accepting the higher risk inherent in the loan. The return on investment (ROI) required of junior lien holders must be highly commensurate with the risky lien position in the capital structure. Junior debt instruments can potentially increase the leveraged 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 to fill the gap in commercial realty’s capital structure occupying a position above senior and sometimes junior debt instruments. Sometimes mezzanine capital is used to bridge the gap if there is a shortfall in collective debt financing or if there is a disparity between the equity position of property investors and the collective debt instruments. This fund is managed to provide its provider with an associated risk premium to compensate for the level of risk associated with the return of principal and unrealized returns. Unlike senior and junior debt instruments, mezzanine debt is generally not collateralized against the underlying realty used in the financing when the structure is in the form of preferred equity and is collateralized against property when issued as debt and used to increase the loan-to-value (LTV) of the debt financing. As a junior lien.

Preferred Equity – is an equity contribution in which the source receives a preferred return on their money at an agreed coupon rate before the sponsor is promoted; A percentage of the profit. This capital structure reflects the position occupied by preferred equity, the associated risks of that position and the associated compensation required to occupy that position. This capital fills the gap between the sponsors’ equity and other financing, reducing the sponsor’s equity at risk in the project. Using preferred equity in concert 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 a real estate transaction to mitigate capital risk while adding some upside to the deal.

Sponsor Equity – Cash contribution is the accumulated market value above other capital structure components for the property or other property owned by the sponsor eligible for cross collateralization. At its simplest, it’s the traditional down payment required by lenders. from borrowers above the loan amount provided to execute the purchase. Equity can be built up as a result of sponsor equity asset appreciation and/or loan principal reduction. This creates equity value in the asset which the sponsor can leverage for portfolio pyramiding, capital improvement, etc. This equity represents the sponsor’s capital at risk which is likely to shrink in case of asset depreciation, foreclosure, etc. Sponsors try to reduce risk by risking their cash outlay or equity by using other financial instruments available in the capital structure as well as by using leverage to increase cash to cash yield.

When financing commercial real estate, not all components of the capital stack are necessarily used. However, they are potential options that can help principals reach their goals. How the deal is structured depends on the parties involved and their objectives, financial markets and assets. However, maintaining flexibility and being aware of the available variables that can be used increases the investor’s tool kit and tendency to be effective in getting deals done.

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