The Capital Stack (Part 1)

You’ve got a project you think makes sense. It makes sense for your team, for the community, for the ultimate end users (the buyers), and your financial model says it will generate positive cash flow in an amount that justifies the investment.  The next step is to figure out how to pay for it.

Just like real estate developers are always looking for the next deal, they’re also always looking for funds.  Only large and well-established real estate companies (think Trammell Crow in office or Toll Brothers in housing) have enough cash within their organization to start and finish projects with their own money.  The typical developer will have just enough cash to prove to others they have some skin in the game and they think the project is good.

The capital stack defines how the project will get paid for and how the parties that invest in the project will share in the financials rewards (or losses). 

If you have a mortgage on your house, you have a capital stack.  You likely had to come up with some portion of the purchase price to buy your home.  That was the equity and that was your way to prove you believe in the value of the house.  You own it, but if you have a mortgage then there is a bank that also has a stake and is part of the stack.

Banks are not in the business of owning houses for long periods of time and trying to make money when they sell five or ten years down the line.  They are in the business of lending money and collecting interest payments on that money.  They’re part of the capital stack required to fund your home, but each party has their own purpose, their own defined financial rewards and risks, and their own protection.

You own your house and your name is on the grant deed recorded with the County, but the bank has a deed of trust recorded on the property that says they can take it from you if you don’t perform.  They want you to pay interest and pay them back the principal over time.  If both parties act as agreed, you end up owning your house and the bank makes decent interest on their loan.

The real estate development business operates under the same principles.  The owner is usually going to put up the first money to buy the land and start the development.  Then you hope to have a bank fund the balance of the project.  However, real estate development is different from a residence because the owner is likely to be a partnership, perhaps an LLC with multiple members, each with different responsibilities and obligations.  Those owners must have an agreement about who is going to fund the upfront dollars and who is going to get money back after any debt is paid off.  The capital stack is often defined in a partnership or operating agreement.

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Author: edmorgan1

I am an accounting and finance professional focused in the real estate development sector in the North Lake Tahoe and Reno area. I have managed the accounting and financing of large master-planned communities in high end resort areas with complex arrangements for large public companies and for private asset managers. I am experienced in GAAP financial reporting, business plans, cash forecasting, variance reporting, audits, treasury management and tax. I have helped companies grow and downsize during the real estate cycle and have a proven ability to manage diverse teams through real estate matters. In my current role I am managing a 900 unit master planned community through a change in ownership and am seeking new residential development opportunities in Northern Nevada.