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Understanding the ‘capital stack’

Alexis Holloway .

Commercial Real Estate (CRE) funding typically comprises different capital sources. Collectively, these sources are often referred to as the ‘capital stack’ with each level having its own distinct risk-return profile and attributes such as collateral requirements and repayment priority.

Depending on the nature, complexity, and location of an underlying CRE security property asset/project, there can be all kinds of variations within the capital stack. However, typically it consists of up to four funding sources or layers:

1. First Mortgage Debt

  • Also referred to as ‘senior’ debt
  • The primary funding source for a CRE development project/levered asset acquisition or investment
  • Typically makes up the majority of the required capital
  • First ranking mortgage security (usually registered) against the security property
  • First in line in the repayment waterfall
  • Buffered by equity (which is the ‘first loss position’) and other subordinated debt
  • Least risk/lowest level of return, currently in the 6-8% per annum range
  • Interest can be capitalised within the loan facility or paid along the way by the borrower
  • Fixed (contractual) return with limited downside

2. Second Mortgage Debt

  • Also referred to as ‘mezzanine’ or ‘junior’ debt
  • Used as an additional layer of debt between First Mortgage Debt and Ordinary/Preferred Equity
  • Second ranking mortgage security (also usually registered) against the security property
  • Second in line in the repayment waterfall (i.e. First Mortgage Debt mortgagee must be repaid in full before any funds become available) and typically required to enter into a priority deed with the First Mortgage Debt mortgagee
  • With higher risks, the holder demands a higher return, currently in the range of 12-14% per annum
  • Interest can be capitalised within the loan facility or paid along the way by the borrower
  • Fixed (contractual) return with limited downside

3. Preferred Equity

  • A hybrid of debt and equity attributes
  • Serves a similar function to Second Mortgage Debt in that an additional layer of capital exists between the debt holders and Ordinary Equity holders
  • Secured contractually to the security property however, not by a registered mortgage instrument
  • Third in line in the repayment waterfall
  • In recognition of its unsecured nature, the investment may be structured with higher return and progressive coupon payments
  • Returns are currently in the 14-16% per annum range, though may go higher with depending on level of ordinary equity participation

4. Ordinary Equity

  • These are the unsecured funds the borrower invests; the capital that is ‘first in and last out’
  • Required by the lender (e.g. Pallas Capital) to ensure the borrower has a strong, vested interest in the success of the CRE development project /asset acquisition or investment and so that the debt provider/s is/are not wholly exposed to any downside (i.e. ordinary equity is the ‘first loss position’ and provides the initial ‘buffer’ or ‘shock absorber’ to providers of debt/credit)
  • The last layer of capital to be repaid in the repayment waterfall i.e. all Debt and Preferred Equity holders require full principal and interest repaid before Ordinary Equity receives any payment
  • Highest risk-return in the capital stack, often the most profitable if the investment is successful (i.e. unlimited upside)

As shown in the diagram, below, these sources are ‘stacked’ on top of each other to fund the project (hence the name, capital stack):

Case Study: No. 1 Carlisle, Rose Bay, NSW 2029

Pallas Capital is highly experienced in the principles and nuances of CRE structured finance (i.e. the capital stack). The recent Fortis development at No. 1 Carlisle St, Rose Bay, provides a good illustrative example. It’s worth noting that, for this project, only two of the four capital stack sources were required: First Mortgage Debt and Ordinary Equity, which is the most common capital structure used to fund a CRE project.

The Funding Scenario

To acquire the prominent Rose Bay site and subsequently deliver the boutique 8-residence development at No.1 Carlisle, the borrower/developer Fortis required $32 million in project capital. This was funded through a two-tiered capital structure. Pallas Capital provided $24.7 million in the form of First Mortgage Debt (equating to 69.4% of the total GRV-Gross Realisable Value). The remaining balance of $7.3 million was contributed directly by Fortis, as Ordinary Equity.

No.1 Carlisle – Capital Stack

First Mortgage Debt: (Pallas Capital) $24.7 million (69.4%)
Second Mortgage Debt: n/a
Preferred Equity: n/a
Ordinary Equity: (Fortis) $7.3 million (30.6%)

The Result

At the time of writing, No.1 Carlisle is in the final stages of completion. The eight luxury residences have already been 100% pre-sold during the construction phase, delivering Project Value on Completion of $40.1 million gross and $37 million net of GST (providing 150% debt cover on the First Mortgage Debt). Pallas Capital investors, as First Mortgage Unitholders, received an average return above 8.0% p.a. on their investment and Fortis as the Ordinary Equity holder (the developer) will realize a return of approx. 22% IRR on their investment.

No.1 Carlisle – Returns

First Mortgage Debt: (Pallas Capital) 8.0% coupon
Second Mortgage Debt: n/a
Preferred Equity: n/a
Ordinary Equity: (Fortis) 22.0% IRR

What if things go bad?

No.1 Carlisle is a great example of things going well. But what if they don’t? Using the same project let’s imagine the development has been successfully completed however, Fortis is forced into administration. As part of their liquidation, Fortis moves to liquidate (sell) the No. 1 Carlisle in Rose Bay asset, against which $24.7 million debt exists.

Pallas Capital, as first ranking secured creditor, has foreclosed on the property and has an interested buyer who is willing to pay $28 million. Given this is less than the $32 million of total capital invested in the project, the different levels and attributes of the capital stack now determine what happens next. Assuming the sale goes through:

  • As the First Mortgage Debt holder and priority in any payment waterfall, Pallas Capital, is repaid in full the $24.7 million loan balance first. A balance of $3.3 million remains from the sale proceeds.
  • With no Second Mortgage Debt or Preferred Equity to consider, the Ordinary Equity holder, Fortis, then receives the remaining balance of the funds (less any sale transaction costs), realising a loss of ~$4 million on their original principal.

Clearly, this is a very simplistic example. However, it demonstrates the critical importance of repayment prioritisation, as well as the differing risk/return potential depending on the position in the capital stack. First Mortgage Debt is the most secured position but earns the lowest return. Ordinary Equity on the other hand is the least secured position though possesses the greatest potential return.

NB. Fortis is wholly owned by Pallas Group and thus a related party to Pallas Capital. However, for the illustrative purposes of the provided downside hypothetical, were Fortis an independent, third-party borrower/developer, the outcome would be the same.

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