Building a Capital Stack

Every real estate development project, on or off campus, will have a “capital stack” – a mix of funding sources and other incentives that comprises the capital necessary to get a deal done. Each capital stack has three components, debt, incentives, and equity, which are explained below. Together, these respective sources combine to create a “cost of capital” for the opportunity – meaning how much it will ultimately have to pay back to each stakeholder. That cost of capital (relative to how much return the project will produce) is very important as it is one of the determinants of whether a project will succeed or fail.

Used and modified with permission from Governance Project

Debt

Debt is the product with which most of us are most familiar. Consumers regularly interact with this source through financial vehicles such as mortgages, credit cards, and student loans – and in the investment world, the same fundamentals apply. Every debt obligation has a principal amount (what you borrowed), an interest rate (fixed or variable), and a repayment term (from a year to 40 years). Those three variables together provide the “cost” of debt, i.e., exactly how much the deal will need to produce in cash flow to repay the debt obligation. Interest rates and term will vary depending on the “credit profile” of the project which takes into account items like (1) value of any collateral put up for the loan, (2) the risk of non-payment, and (3) broader macroeconomic conditions (like the Federal Reserve Rate). To better understand the debt component of a deal, we recommend experimenting with the Governance Project’s GroundUp tool. This tool will serve to demonstrate how long-term debt (or lower-priced debt) can ultimately impact the return profile for an equity investor. For more on available debt sources, see Capital Sources.

Incentives

Incentives are “free money” – cash, tax credits (historic, new markets, low income housing, etc.), land, or other potential tools that can provide a direct subsidy to the project. Incentives and equity are inversely related; the more incentives a deal can attain, the less investor equity will be needed in the project’s capital stack to get the project “across the finish line”. It is very important to note that these incentives will improve the return profile for investors, as you can see by experimenting with GroundUp. For more on available incentives, see Capital Sources.

Equity

Equity is what the owner (or owners) of a project contribute to get a deal done or a business operational. Equity is viewed as an ownership percentage – if you’ve contributed 100% of the equity of a project, you own 100% of its assets and have the right to 100% of whatever cash flow is left over once you’ve paid your expenses and your debt. Bringing in outside investors – like an Opportunity Fund in the OZ context – means that initial equity ownership percentages in the project will be reduced (or “diluted”). Typically, it reduces proportionately to how much the outside investor brings in, e.g., if I contribute $500,000 to a venture and my friends contribute $300,000 and $200,000, my ownership percentage would reduce to 50%, and they’d own the remaining 30% and 20% of the business, respectively. If debt is all about “credit profile” and risks, equity is all about the “return profile,” which looks at the potential “upside” of a deal over time. For more on available equity sources, see Capital Sources.

Capital Stacking Tool

To help you understand how capital stacking works in practice, try playing with the simple return calculator.