The crucial role of debt in the capital stack for commercial real estate projects

In the specialist world of financing real estate projects, particularly in the commercial real estate (CRE) sector, a strategic interplay of financing strategies is essential. The capital stack, representing the funding structure for acquiring existing properties or initiating development projects, is of particular significance.

Debt is arguably one of the most foundational parts of this process, forming an important structure, and often, significant portion, of the total funding. This article delves into the critical role of debt in CRE financing and explores the various types and layers. Additionally, it addresses the associated risks for investors and demonstrates how debt shapes the overall funding structure within the capital stack.

Debt is dynamic

Debt plays a pivotal role in the capital stack, often forming the fundamental layer for financing real estate development projects. Developing a commercial real estate property requires substantial investment to cover elements such as land acquisition, demolition, construction, and ongoing maintenance until the property reaches stability. The duration and risk associated with this process vary based on factors like property size, development complexity, and speculative nature. Given these challenges, developers often seek financing from sources that can tolerate such risks, combining both debt and equity funding to support the project.

Simultaneously, investors often favour debt investments for the security they can offer, preferring the stability and predictability of returns that are often secured by mortgages over property, over the volatility of equity investments. Debt can provide investors with a reliable avenue to diversify their portfolios while enjoying predictable returns.

Debt is a critical tool for both property developers and investors. Developers rely on debt to access the necessary funds for acquiring land, construction, and completing projects. It helps them manage upfront costs and project risks more effectively. Similarly, investors prefer debt investments for their stability and fixed returns, offering a secure alternative to equity investments. In this way, debt plays a vital role in facilitating the goals of both developers and investors in real estate projects.

Understanding the different layers of debt in the capital stack

The capital stack incorporates various layers of debt, each with its own risk-return profile. Here’s a breakdown of two key categories:

Debt is not dirty

It’s important to note that a higher proportion of debt in financing commercial real estate projects doesn’t necessarily equate to higher risk. This is because lenders typically extend financing to properties they deem capable of managing the associated credit risk, with income levels sufficient to support the debt.

In the past, investors often took comfort from the scale and sophistication of tier 1 builders / projects, and for good reason. These projects perform well for investors when all goes to plan.

However, if cracks start to appear, unexpected risks may start to present through. For these reasons, and as part of our risk-mitigation discipline, we strategically work with projects in the $3 million to $50 million range which often have better margins, typically 7-10%.

Given Zagga’s deep experience in development projects and construction funding, we look beyond what independent quantity surveyors present, to identify conservative contingencies to help manage a project seamlessly and successfully through to Practical Completion, and ultimately, loan repayment.

Most real estate lenders, particularly those offering senior debt prioritise capital preservation above all else. At Zagga, we operate with an investor-first approachOur focus and objective is on presenting risk-mitigated commercial real estate debt opportunities, which, when compounded over many years, constitute highly attractive returns.

Debt is a powerful tool

Debt financing plays a vital role in unlocking opportunities in the commercial real estate market for developers and investors. By leveraging debt strategically within the capital stack, investors can amplify returns. However, debt investments, as with all investments, carry risks. Understanding the nuances of the capital stack, the different layers of debt – such as senior debt, junior debt and mezzanine debt, along with the key risk factors, are all crucial elements for making informed investment decisions. When wielded with care and a thorough understanding of the commercial real estate debt market, debt can be a powerful tool to help investors achieve risk-adjusted returns and regular, predictable income.

This article is for information purposes only. It does not take into account your objectives, financial situation or needs. Any opinion expressed in this article are of the author and is subject to change without notice. Readers are reminded to exercise caution and use their own judgment when interpreting and applying the information contained in this article.

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