The crucial role of debt in the capital stack for commercial real estate projects

Debt plays a pivotal role in the capital stack, often forming the fundamental layer for financing real estate development projects. Developing a commercial real estate property requires substantial investment to cover elements such as land acquisition, demolition, construction, and ongoing maintenance until the property reaches stability. The duration and risk associated with this process vary based on factors like property size, development complexity, and speculative nature. Given these challenges, developers often seek financing from sources that can tolerate such risks, combining both debt and equity funding to support the project.

The capital stack incorporates various layers of debt, each with its own risk-return profile. Here’s a breakdown of key categories:

1.  Senior debt: Senior debt is a form of financing that holds the lowest risk, and highest priority for repayment, in the capital stack. In essence, it’s the first in line to be repaid in the event of asset liquidation or cash flow distributions. For investors, senior debt represents a lower risk investment option within the capital stack compared to other forms of financing and layers within the capital stack. This is because senior debt investors are prioritised in repayment over other creditors, including subordinated debt investors. This type of debt typically carries lower interest rates compared to other forms of financing, reflecting its lower risk profile.
2. Subordinated debt: Following senior debt in the capital stack hierarchy lies subordinated debt which includes mezzanine debt as well as junior debt. Subordinated debt occupies the middle ground between debt financing and equity investment.
3. Junior debt: Junior debt is simply a percentage of the loan that sits below the senior debt in the capital stack. Not all commercial real estate projects will have junior debt. The key difference between senior and junior debt is that the junior debt ranks after senior debt in repayment priority, although still ahead of equity, and charges a slightly higher interest rate on the capital provided to reflect its higher risk profile.

   For real estate projects that do not have a junior debt layer, the capital after the senior debt will often come in the form of mezzanine debt, or preferred equity, instead of junior debt but often serve the same purpose of bridging the gap between the amount of common equity needed and the amount of debt provided by the senior lender.

4. Mezzanine debt: Similar to senior debt, mezzanine debt offers investors regular interest payments at a predetermined rate. However, it ranks behind senior debt in repayment priority in the event of default or asset liquidation. As such, mezzanine debt carries a higher interest rate compared to senior debt reflecting its higher level of risk.

   Despite this lower repayment priority risk, mezzanine debt is still debt and in the real estate capital stack, all forms of debt are of higher seniority and higher repayment than equity. This hierarchy means that the lenders must be repaid in full before equity holders can start to recover any proceeds. As such, equity holders could receive a marginal recovery on their investment, or nothing at all in the event of default.