What Is a Capital Stack and Why Should You Care?

Topic:  • By Origin Investments • December 22, 2015 Views

What Is a Capital Stack and Why Should You Care?

The capital stack is all about your position in the hierarchy of finance.

The big picture is that all investments you make with Origin are at the top of the stack, in the equity, meaning you own a piece of the asset.

This is the higher risk, higher reward position.

In the simplest terms, when things go well, everyone wins, but you win more. When things go poorly, you are the last to get paid back. Your position in the stack also determines your tax treatment.

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The stack is divided into two large categories:

Equity, which is at the top and involves ownership.

Debt, which is at the bottom and involves lending money for the property’s acquisition. Just like when an individual defaults on a home mortgage, if a deal goes into default, the lenders get to seize the building via foreclosure.

Lending money to real estate deals provides investors a steady stream of cash via monthly debt payments, but there are no tax benefits to this. The income is taxed as ordinary income.

The greatest risk here is inflation as it lowers the purchasing power of those monthly cash streams because they’re fixed. In other words, if inflation goes from 1 percent to 3 percent, lenders are still getting paid the same amount, say $100, every month. That $100 just won’t get you as far.

Unlike debt holders, equity holders get to participate in the full appreciation of the asset; buying low and selling high makes equity holders, not debt holders, money.

(Article continues below video)

Learn how commercial real estate properties are financed with this explainer video.

At Origin, after we turnaround a property, equity holders on most deals also receive regular dividends, which, like debt, offer a steady stream of cash flow.

These returns also receive favorable tax treatment. The dividends are largely shielded from taxes thanks to what’s known as a depreciation tax shield. Any dividends that aren’t shielded are subject to ordinary income taxes.

The depreciation tax shield is at the heart of almost all corporate financial strategies but all that’s necessary to know is that it helps holders of equity in commercial real estate.

There are even more tax benefits for equity holders when a property is sold.

Let’s say Origin buys a building for $10 million and four years later sells it for $12 million. In those intervening four years, Origin depreciates the building on its books by approximately $350,000 annually, leaving an $8.6 million asset on the books. (That’s where those tax savings mentioned above come from.)

The $1.4 million gain on the sale — from $8.6 million to $10 million — would be taxed at 25 percent, which is less than the ordinary income rate for our investors. The additional $2 million in profit — from $10 million to $12 million — would be subject to the 20 percent long-term capital gains rate, which also less than the ordinary income rate for our investors.

Point being, contributing equity to commercial real estate deals is quite tax efficient. That’s intentional. It’s designed as a reward for moving higher up in the capital stack and taking on more risk.

 

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Origin Investments

Origin Investments is a top-ranked real estate firm committed to educating investors on private equity commercial real estate.