Understanding the Capital Stack and How It Affects Your Investments
Published on Feb. 14, 2013
Understanding an investment's place in the "capital stack" is one of the most important aspects of due diligence an investor must complete prior to making any investment. The "capital stack" refers to the legal organization of all of the capital placed into a company or secured by an asset through investment or borrowing. The capital stack determines who has legal rights to certain assets and income, who receives priority of payment in the event of an uncured default, and in which order each party may be repaid or given authority to take over or liquidate assets in the event of a bankruptcy. Simply put, your place in the capital stack can make all the difference in the world between a complete loss and full recovery of your investment when things go wrong.
With just about every investment you make, your place in the capital stack determines the amount of security or downside protection and upside potential you receive. Your place in the capital stack also determines which tax benefits (or lack thereof) you are eligible to take and how you are able to categorize the income you receive from an investment. Understanding your place in the capital stack is of equal importance and goes hand in hand with understanding the collateral and value that ultimately back your investments.
The Company Collateral Capital Stack
The following is a detailed breakdown of an idealized capital stack for the company category of collateral (which includes stocks, bonds, annuities, etc). Note that seniority of security and priority of claims increase as one goes from top to bottom. Thus, the lower you are in the capital stack, the more secure your position.
|Equity (Common Stock)|
|Preferred Equity (Preferred Stock)|
|Junior Unsecured Bonds|
|Senior Unsecured Bonds|
|Junior Secured Bonds|
|Senior Secured Bonds|
In the event of a bankruptcy that results in liquidation, taxes would be paid first, followed by employee wages, senior secured bonds, and so forth down the line until all net liquidated capital is distributed based on priority and seniority within the capital stack. Generally, by the time the secured bondholders have been paid back (assuming that there is sufficient liquidated capital to such point), unsecured bondholders are left with a fraction of what they were originally owed by the company, and common equity (common stock) and preferred equity shareholders are entirely wiped out.
Though it is rare, in some cases of extreme indebtedness or fraud, even the secured bondholders may have trouble recovering all capital owed. The value of the assets securing the bonds may be the only potential recovery for secured bondholders in these cases. If there are not enough liquid funds to pay secured bondholders, the bondholders can take over the assets securing the bonds and then decide thereafter whether to hold the assets for some other productive use or liquidate them to attempt to recover a portion of the capital owed.
Even though an investor may hold a senior secured position, money is still made or lost based entirely upon the difference between the value of the assets securing the bondholders and the amount of capital originally placed to own the bonds. While it certainly helps protect one's principal by being in a senior secured position, this does not guarantee safety of principal. One must know his position in the capital stack and the value of the collateral backing his investment.
Real Estate Collateral Capital Stack
The next most common capital stack is that of commercial real estate, as depicted below in idealized form:
|2nd Position Mortgage|
|1st Position Mortgage|
|Real Estate Taxes|
While some real estate investments may have a very simple capital stack such as equity only or equity and a first mortgage, the capital stack depicted above is a more-detailed example that exists in various forms in highly structured commercial real estate investments. As with company collateral, assuming that the real estate taxes are caught up, the first mortgage is in the most senior, protected position. In the event of a borrower default, the preferred equity must keep payments current with the mezzanine lender who, in turn, must keep payments current with the second position lender...who must keep the senior loan current with the first position lender who, in turn, must ensure that the taxes are paid if all the other positions in the capital stack fail to do so. A default anywhere along that chain allows the party defaulted against to ultimately take over the property from the defaulting party. If property values drop substantially enough and if the property's income is affected enough, this could cause a multiparty default, allowing only the most secure parties (likely the first and/or second position lenders) to take back the asset under foreclosure.
In situations of severe default, if the taxes are not paid, a tax lien may be placed against the property. This lien gives the taxing authority the ability to have another party satisfy the lien and eventually take over ownership of the property. Past taxes and penalties typically remain with a property and must be satisfied to clear title regardless of what happens with a property's mortgage(s) or equity ownership and thus are considered to be the most secure position in the capital stack of real estate.
As with the corporate capital stack, being a first or second mortgage holder (or even a tax lien holder!) does not guarantee an investor the protection of capital invested. Ultimately, the value of the collateral is the determining factor. The more senior one is in the capital stack (i.e., the more secure), the better, but if the capital investment ultimately exceeds the value of the property, an investor may be subject to a capital loss upon liquidation or additional capital requirements to manage and hold the property long term. Alternatively, the higher the value of the underlying asset(s), the less senior one can be in the capital stack (i.e., the less secure) and still be well collateralized.
Practical Application of the Capital Stack in Investment Decision Making
If an investor cannot tolerate a higher potential of capital loss, low loan-to-value first mortgage positions in quality real estate and junior and senior secured corporate bonds in strong, credit-worthy corporations are generally the most secure investment positions to consider. The capital risk of these investments tends to be very low, as are the returns, reflecting the lower potential for capital loss. Inflation tends to be the largest risk in these types of investments since the returns tend to be fixed at lower rates for extended periods of time. There are usually no income or capital gains tax benefits for these types of investments.
If an investor is more concerned about achieving capital appreciation or hedging against inflation and can tolerate more risk, real estate equity and stock investments may be the position in the capital stack to consider. Investors on this end of the capital stack must be additionally sensitive to fluctuations in valuation of the underlying collateral of their investment since they are first in line for any losses and last in line for any recovery in worst-case liquidation scenarios. With regard to upside, equity and common stock positions are the primary beneficiaries for any potential gains, and certain equity structures are able to qualify for tax benefits that can further incentivize investment in this higher-risk side of the spectrum.
Many of the investment structures in the middle of the capital stack have gradations of higher return with each level of additional risk. Generally, only equity-based investments can utilize certain tax benefits, whereas debt-based investments are exposed to ordinary income taxes and do not have regular tax deferral mechanisms.
Putting the Capital Stack to Work
Beyond these general guidelines, the best way to apply the capital stack is to take the total estimated value of the investment being acquired and organize the value from the most secure position in the capital stack to the least. This exercise will demonstrate how much "cushion" each position has from loss based on current values and will provide a guide for how much value can fall before affecting each respective position.
Here is an example of a million-dollar property based on a common capital stack (assuming property taxes are current) of a 20% down payment (equity) 65% loan -to-value first mortgage, and a 80% loan-to-value second mortgage (65% + 15% second = 80% total loan to value). In this example, the property is producing annual Net Operating Income of $100,000.
|2nd Position Mortgage||$150,000||15%||80% combined LTV|
|1st Position Mortgage||$650,000||65%|
Example 1 – When Things Go Well
If the first mortgage has a mortgage payment of 7% interest only per year and the second mortgage lender has an interest rate of 10% interest only per year, this would leave the equity investor with a net annual return of 19.75% ($650,000 x 7% = $45,500 + 150,000 x 10% = $15,000 for a total of $60,500 in debt payments subtracted from $100,000 NOI = $39,500 net cash flow divided by $200,000 capital investment). The equity investor can take the property's depreciation to reduce the tax impact of the cash flow. ($1,000,000 of property value less $100,000 of land value, which cannot be depreciated = $900,000 of depreciable value divided by 39 for commercial property and 27.5 for residential property).
In this case, let's assume that we are dealing with an apartment complex, and thus a 27.5-year depreciation schedule. We would divide the value of the aprtment complex excluding the land ($900,000) by 27.5, which would result in $32,727 to be taken as depreciation expense against the income every year for the next 27.5 years. So, even though the equity investor is receiving $39,500 in net cash flow, he is having to show income of only $6,773 ($39,500-$32,727) for tax purposes! At a 30% tax rate, this depreciation benefit has reduced his tax bill from $11,850 down to $2,032! This represents an additional 5% of return per year on his originally invested equity.
If the property appreciates in value, say to $1,150,000, the equity investor would retain the additional $150,000 of profits on top of the $200,000 return of capital after paying off the first and second mortgages (totaling $800,000). The total principal owed and annual payments are fixed, so any upside is entirely the equity owner's to enjoy. At this point, the equity owner could elect to complete a 1031 exchange and entirely shelter the capital gains ($150,000) from taxes—a savings of approximately $37,500 to $45,000 depending on the state of residence (and even higher in 2013 for many due to the increase in capital gains for certain levels of income).
So when the property performs at par or better, the equity position makes out the best. The second mortgage holder makes out fairly well compared to the first mortgage lender, earning 10% rather than 7%. The first mortgage lender makes the least, but retained the most secure position throughout the hold.
Example 2 – When Things Go Poorly
On the other hand, let's say that this property does not perform so well, and instead begins to underperform on an income and value basis. Now, NOI has dropped from $100,000 to $30,000 and the value has dropped from $1,000,000 to $600,000. The debt payments stay fixed, so the equity investor has to come out of pocket a total of $30,500 to pay the uncovered portion of the total debt service of $60,500. This continues year after year until the equity investor simply cannot (or will not) afford to continue paying.
Now that the equity investor has defaulted, the second mortgage lender is no longer receiving the $15,000 of income per year and is also on the hook for another $15,500 per year ($45,500 is due to the first mortgage lender and there is only $30,000 of income available from the property). Since the property value has dropped below the value at which the second mortgage lender loaned money, the second mortgage lender cannot simply sell the property to make the property current, but must decide whether or not to default or try to work out a deal with the first mortgage lender.
If the second mortgage does not maintain payments to the first mortgage, the first mortgage lender can declare a default, foreclose, and then can decide what to do with the property. Even though the property value has dropped significantly (down to $600,000 from $1,000,000), the first mortgage lender has only potentially lost 7.69% of its original capital loaned if it were to decide to liquidate the property quickly. If the first mortgage lender decides to simply hold the property and wait for values to come back, the annual return would be approximately 4.6%. That is not the 7% originally anticipated, but it is also not that bad of a result for what is otherwise a worst-case scenario for all other portions of the capital stack.
The true risk level of an investment cannot be understood apart from the knowledge of one's place in the capital stack of an investment. The capital stack position controls how an investor's collateral is accessed, what level of return can be expected, what tax benefits are available, and ultimately, the level of downside and upside to which an investor is exposing his investment. Typically, if you cannot easily discern an investment's position in the capital stack, you do not understand the investment that you are making!
Protecting your capital is the foundational principle of wealth management. Knowing your position in the capital stack and the collateral that backs your investments are essential to growing and protecting your wealth. At JRW, we make it a strict discipline to analyze our clients' position in the capital stack as it relates to their investment's collateral so that we can properly assess their downside risk and upside potential.