Have you ever been in an investment committee meeting and heard your VP of Acquisitions talking about things you didn’t understand? In the “Development Jargon” series I hope to demystify the language of development. If you have suggestions for future demystifications, let me know on twitter!

Today I am going to explain the Capital Stack. In addition to simplified definitions of the terms and components I will provide a few exercises to test your newfound knowledge.

The capital stack describes the total amount of funds used to purchase a property. The capital stack is usually a combination of sources of equity and debt.

The capital stack describes the total amount of funds used to purchase a property.

Leverage

Leverage is expressed in percentage form and is the total amount of debt from any source divided by the purchase price. If a $60M loan and $40M in cash is used to purchase a $100M property, that deal has 60/100=60% leverage.

Leverage = Total Debt / Purchase Price

Leverage can be expressed in two forms. Loan to Cost (LTC) or Loan to Value (LTV). In a development deal where the costs are known but the ultimate value of the project has yet to be determined, leverage is typically expressed as LTC. In an investment where the purchase price is known, LTV is common.

Hopefully, as the development project gets completed and leased up, the value of the project increases. As the value increases for the same size loan the LTV becomes less than the LTC.

Sources of Equity

Equity used to purchase a property can come from many sources, but they typically falls into two categories: General Partner (GP) Equity or Limited Partner (LP) Equity.

The GP is usually the firm or partner who found the deal — the deal partner — and is managing the investment. They have more impact on the project and have a fuller understanding of the deal so they are willing to take on more risk. They are typically compensated for this additional risk as well.

The LP is usually an outside investor. They are the capital partner. Their largest value to the project is as a source of capital whereas the GP’s largest value is the source of the deal.

The LP will often not take on the same amount of risk as the GP — they won’t sign guarantees for example — and therefore they will be compensated in a different structure than the GP. Less risk, less reward. However, the LP typically contributes a majority of the equity capital. It’s not uncommon for the LP to provide 75–95% of the equity.

The GP will almost always be required to contribute some equity — 5–10% or more — this is their “skin in the game” and ensures they have alignment of incentives with their LP partners and the debt.

Sources of Debt

Debt is the other main source of funds in the capital stack. Debt is a fixed sum of money that also has a fixed repayment schedule. Unlike equity, you are contractually required to pay back debt. Typically an investor signs guarantees to give the lender additional security in the loan.

Debt is a fixed sum of money that also has a fixed repayment schedule.

Debt is considered a less risky financial position than equity because of the fixed value, fixed repayment schedule, and guarantees. The lower risk means the lender typically sees lower returns on a deal than the GP and LP.

Debt typically comes from a bank or other large financial institution.

Sometimes an investor takes out two loans. The second loan usually agrees to get repaid after or, on a lower priority, than the first loan. This is a riskier position for the second loan to be in. The second loan “sits on top” of the primary loan in the capital stack — it is higher up the risk spectrum — and is often called a mezzanine loan or “mezz” debt.

Relative Value of Equity

Unlike the value of the debt, the value of the equity changes over time. Once the investment is made, the value of the equity equals whatever funds are left after a sale and the debt is repaid. As the value of the investment changes over time and/or the debt is paid off, the value of the equity changes. If the value of the property goes down the value of the equity can be zero or negative.

Pursuing this additional risk and being compensated for it is how equity investors make — and sometimes lose — their money.

Conclusion

I hope you enjoy this explanation of the capital stack. Please take some time to try the exercises below. If you have any questions about the exercises or anything I discuss above, just reach out! My email is [email protected].

Exercises

1. If a GP investor is contributing 10% of the equity on a $100M investment with 75% leverage, how much equity is she contributing?
2. Who sits in a riskier position in the capital stack, the mezz lender or the LP?
3. What is the leverage on an investment where the GP contributes $1M, the LP contributes $9M, a mezz lender contributes $20M, and a bank contributes $70M?

If you have suggestions for future demystifications, let me know on Twitter!