What is the capital stack?

The capital stack is a term used in finance, particularly in real estate and corporate finance, to describe the different layers of financing sources that make up the total capital invested in a project. The capital stack reflects the hierarchy or order of claims on the project’s assets and income. Each layer of the stack has different levels of risk and return.

Here’s a breakdown of the typical components, from the lowest to the highest risk:

Senior Debt: This is the lowest risk layer, usually secured by assets or a lien against the property. It has the first claim on any cash flows or in the event of liquidation. It generally offers lower returns relative to riskier layers.
Mezzanine Debt: Positioned between senior debt and equity, mezzanine financing is typically unsecured or has a subordinate claim and carries higher interest rates. It often includes options or warrants that can be converted into equity.
Preferred Equity: This component is riskier than debt but safer than common equity. Preferred equity holders have a preferential claim over common equity on earnings and in liquidation but are subordinate to all debt. They typically receive fixed dividends.
Common Equity: This is the most junior layer in the capital stack, bearing the highest risk. Common equity holders benefit from the highest potential returns because they participate directly in the success of the project but are the last to receive payments in cash flow distribution and in liquidation scenarios.
Understanding the capital stack is crucial for investors and financiers, as it helps in assessing the risk and potential return on investment, as well as understanding their position in the event of a project’s underperformance or failure.