How to Lower the Cost of Your Capital Stack: Debt vs Equity

If you are involved in any sort of commercial real estate investment, one of the most important things you will need to think about is the capital stack. The capital stack, essentially, is a term used to describe the totality of all capital involved in the project. For many projects, especially those being conducted on a much larger scale, there will be several different types of capital involved—as you will soon learn, not all capital should be considered to be interchangeable. 

In many projects, particularly large-scale projects, the capital involved will originate from multiple different locations. This might include common equity, preferred equity, mezzanine debt, and other types of debt. Both debt and equity play an important role in the financing process. Each form of capital, as you’d probably expect, comes with several different benefits and drawbacks. 

Working with an experienced commercial real estate (CRE) finance broker can help you create a capital stack that is ideal for your project. The finance broker will help you navigate the “big maze” the comes with CRE financing and make it much easier to establish a personalized finance package. They’ll consider many different relevant variables including the need for control, your exposure to risk, and—perhaps most importantly—the total cost of accessing equity. 

Below, we will discuss the benefits of debt financing, equity financing, and how these two different types of financing can affect your overall capital stack. 

The Benefits and Drawbacks of Equity Financing 

With equity financing, your firm can accumulate additional capital by selling ownership in a specific project or even a specific company. In the commercial real estate market, there are two primary types of equity financing: common equity and preferred equity. Each of these types of equity, depending on the organization and how it is structured, will various privileges and obligations that come with it. 

The most obvious benefit of equity financing is that it does not create any future obligations. There are no debts that will need to be paid in the future—as soon as you have the capital that has been raised via equity financing, it is yours to spend and use as you see fit. This causes equity financing to be especially appealing to commercial real estate firms that need to raise capital quickly but might be concerned about near-term cash flows. 

The biggest drawback of equity financing is that, by issuing equity, your firm is surrendering some rights and control. Your equity investors are investing with the expectation of generating some sort of future return. Usually, this means dividends, profit-sharing, voting rights, asset appreciation, and other forms of value generation. If the project is indeed a success, you will only be able to enjoy some of the wealth being generated, while the remainder is distributed to the holders of the equity. 

The Benefits and Drawbacks of Debt Financing 

Firms that want to maintain complete control of the project (or company) will typically prefer to finance by issuing debt. As your commercial real estate finance broker will help explain, there are many different types of loans available for CRE borrowers. The capital stack might include fixed-rate loans, construction loans, bridge loans, mezzanine loans, agency loans, and numerous others. Many projects require several different loans, from several different lenders, in order to come to fruition. 

However, while debt financing does entitle you to more control—and the right to claim any potential future profits—debt also comes with obligations. Debts will need to be repaid, eventually, meaning the moment you begin borrowing you are creating future financial liabilities. If cash flows lag behind debt obligations, you may end up facing future solvency issues. Additionally, debt has costs that come with it—the compounding interest rate will directly raise the cost of the underlying capital stack. 

Balancing Debt and Equity: The Hybrid Approach 

In the complex, ever-changing world of commercial real estate investment, there is no “one-size-fits-all” approach that will necessarily work for every project or every company. There will be many competing interests involved when creating the capital stack; you will need to carefully balance the simultaneous (and competing) needs to minimize the cost of capital, maintain control and rights, and also ensure you have the financing flexibility to make future changes, as needed. 

Oftentimes, the most effective capital stacks will include both debt and equity sources of financing. Financing will also frequently take place over the course of multiple rounds, meaning you do not necessarily need to have a plan in place to finance the entire project from the very beginning. 

The hybrid approach, ultimately, helps protect your capital stack against the future unknown. If the project goes as planned (or even better than planned), maintaining some degree of equity will entitle you to enjoy the financial benefits of your hard work. If the project experiences future cash flow issues—which, in an increasingly unpredictable world can certainly happen—you will not be overwhelmed by the near-term liabilities that financing the capital stack via debt creates. 

The Benefits of Working with a CRE Finance Broker 

In this industry, you will very rarely find “easy” answers to your financing needs. However, there are certainly many different individuals and firms that can help you navigate the many moving pieces involved in the commercial real estate financing process. 

A CRE finance broker, like you might find at Lincoln James Capital, is someone that will carefully walk you through every step of the financing process. They can help initiate loans, design a personalized capital stack, balance debt and equity financing, and help ensure the mortgage and financing are fully secured. 

Every commercial real estate project is unique, which is something that should be reflected in your personalized capital stack. Whether you are hoping to finance office space, commercial space, industrial space, multi-family living, or anything else, you are going to need to take the time to review all possible financing options. 

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