As I discussed in my most recent article, there are plenty of reasons why real estate investors may use “leverage” – other people’s money – to earn a higher return on their own investment.
There are a lot of different potential routes to take, though, when one is trying to raise money for a project. The kind of money you get may be as important as the total value of financing you’re able to line up – because different money means different things.
Real estate professionals speak in terms of the “capital stack.” This refers to the different “layers” of money and the varied strings that are attached with each layer. Generally speaking, as you move “up” the capital stack, you enter zones of increasingly higher risk – but also potentially higher rewards. The chart below indicates the three major “layers” of the “stack” – think of it as a “money pyramid.”
The three major layers of the real estate finance capital stack
- Senior Debt. This is the bank, or someone acting like the bank, who has to be paid back no matter what. If you don’t keep up with payments, the bank will utilize the security interest that it likely demanded as a condition of making the loan – the mortgage – to foreclose on the property and essentially take away everything you’ve worked for.
- Equity. This is your true ownership position. Owners get all the upside if the property appreciates in value – but also take the “first loss” if things go wrong. This could be the investor by himself, or else he might try to “syndicate” – share — pieces of the equity piece with others.
- Mezzanine Financing. This is an in-between space that can sometimes be pretty interesting for both borrowers and financiers. Mezzanine financing is a kind of debt, generally, but comes in “second position” after the senior loan. That makes any lien harder to enforce – it’s often hard for the 2nd position lien to take enforcement action without the senior debt going along – but the return rates are generally much higher in this space. Thus, while this is a bit riskier place to be for a lender, if the project looks promising enough then the higher returns usually associated with this level of the capital stack may well be worth the increased risk. The company I work with, for example, has a number of product offerings in this portion of the capital stack.
How does it all work for real estate financing?
For active investors looking to raise money for a fix-and-flip project, the senior debt is the cheapest source of financing. That lender, however, will not only want the senior position on the mortgage, but also will usually only loan up to 60-70% of the purchase price of a property, to give itself a hefty “cushion” of equity or other financing positions that, in a downturn, will be hit first. This financing gets an investor a good portion of the way there – but the remaining amount of needed funds may still be too much for the investor to handle alone.
Mezzanine financing may get an investor most of the way to the reminder of the money needed, but it’s usually more expensive than senior debt. Because it’s riskier for the lender (closer to the top of the pyramid), and more likely to be adversely affected if the property’s value decreases, the interest rates will be higher. Nevertheless, if an investor would rather pay a fixed interest rate to an investor instead of giving up all of the project’s upside, then mezzanine financing can be a great way to go.
The equity position keeps all of the project’s upside. Lenders get their interest rates, but if the property has significantly appreciated, it’s the equity that gets to reap those rewards. However, the equity also bears the first risk of loss. Moreover, often even with the other financing raised, an investor still needs some help at this level. The investor can turn to his friends and family to take a share of the project, or perhaps turn to one of the other financing sources that have arisen recently.
Where to find all this financing?
Many financing sources are now accessible online, at an investor’s convenience. Some of these online marketplaces have begun to provide funding for the entire capital stack. These financing sources, often working with crowdfunding techniques (perhaps raising the money from your neighbor!), understand that different financiers have different risk appetites. Some may like the safety of a first-lien mortgage; others may be interested in the higher returns associated with a mezzanine position; and still others want a shot at the equity position’s potential upside (and perhaps some of the tax benefits associated with real estate ownership).
Each of these financing layers has different costs associated with it. It is the active investor’s job to figure out the numbers, and to see which combination of financing sources may work best for his particular project.
Lawrence Fassler is the corporate counsel of RealtyShares, a leading online real estate marketplace. The author does not make investment recommendations or provide investment advice, and this article should not be construed as such. He blogs regularly on real estate finance issues.
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