Real estate investors often begin the financing process by asking a familiar question: “Where can I get the best loan?”
That question makes sense, but it can be too narrow.
A real estate transaction is not always solved by finding one loan with attractive terms. The larger question is how the entire transaction should be financed. That includes the amount and type of debt, the investor’s equity contribution, additional capital sources when needed, reserves, project costs, and the strategy for eventually refinancing or repaying the financing.
This is the difference between loan shopping and capital stack design.
Loan shopping focuses on comparing individual financing options. Capital stack design looks at how different sources of capital work together to support the transaction.
For straightforward deals, comparing loans may be enough. For acquisitions, redevelopment projects, value-add properties, mixed-use transactions, and other situations with multiple financing needs, the structure can matter just as much as the individual loan.
Understanding that distinction can help investors and brokers evaluate financing more strategically.
What Is Loan Shopping?
Loan shopping is the process of comparing financing options.
An investor may evaluate factors such as loan structure, repayment terms, documentation requirements, recourse, prepayment provisions, and other relevant conditions.
The goal is usually to identify the financing option that appears to fit the transaction best.
There is nothing inherently wrong with this approach. Comparing financing alternatives is a normal part of making an informed borrowing decision.
The problem occurs when the investor evaluates the loan without evaluating the complete capital requirement of the transaction.
A property may require more than acquisition financing.
There may also be renovation costs, closing expenses, carrying costs, reserves, tenant improvements, leasing costs, construction expenses, or other capital requirements.
Finding an attractive loan does not automatically mean the entire project is properly capitalized.
What Is Capital Stack Design?
The capital stack describes the different sources of money used to finance a real estate transaction.
At a basic level, a transaction might include:
- Senior debt
- Investor equity
- Additional debt or subordinate capital where appropriate
- Partner or outside equity
- Other transaction-specific capital sources
Not every deal requires multiple layers.
A larger redevelopment project could involve a more complicated structure because the property must be acquired, improved, operated during the project, and eventually refinanced or sold.
Capital stack design asks a broader question:
How should the entire capital requirement be structured so the transaction can be executed according to the investor’s plan?
That shifts the focus from choosing a loan to designing the financing strategy.
Why the Financing Structure Matters
The financing structure can affect nearly every stage of a real estate investment.
Consider an investor who finds financing for the property acquisition but fails to adequately plan for renovation expenses and reserves.
The acquisition may close successfully, yet the investor could still face a capital shortage during the project.
The opposite problem can also occur.
An investor may focus heavily on maximizing borrowed capital without considering how the resulting debt burden fits expected property cash flow or the exit strategy.
The highest available loan amount is not automatically the best financing structure.
Investors need to consider how financing interacts with the actual business plan for the property.
For example, an investor acquiring a stabilized rental property may have very different financing priorities from a developer purchasing a vacant mixed-use building that requires substantial redevelopment.
The property may be real estate in both situations, but the capital requirements are different.
Capital stack design helps connect financing to the transaction itself.
How to Build a Capital Stack Around the Deal
Capital stack planning usually starts with the project rather than the loan.
Step 1: Define the Total Capital Requirement
First, determine how much capital the transaction actually requires.
For an acquisition, that may include more than the purchase price.
Depending on the project, investors may need to consider:
- Purchase price
- Closing costs
- Renovation or construction costs
- Carrying costs
- Reserves
- Tenant improvements
- Leasing costs
- Professional fees
- Other project expenses
The goal is to understand the full capital need before deciding how to finance it.
Step 2: Identify Available Equity
Next, determine how much equity the investor or ownership group plans to contribute.
Equity affects the amount of financing required and can influence the overall risk profile of the project.
Investors should also consider whether all available cash should be committed to the transaction.
Using every available dollar for closing could leave the project without sufficient liquidity for unexpected expenses.
Step 3: Determine the Role of Debt
Debt should serve a specific purpose within the transaction.
For one property, the debt may primarily finance acquisition.
For another, the financing may need to support acquisition and improvements before the property reaches stabilization.
The appropriate debt structure depends on the property, project plan, borrower profile, documentation, exit strategy, and other material factors.
This is why comparing loans without first defining the financing need can create problems.
Step 4: Identify Any Financing Gap
Once the planned debt and equity are compared with the total capital requirement, a financing gap may become visible.
Suppose a project requires $2.5 million in total capital.
If the planned debt and investor equity together provide $2.2 million, there is still a $300,000 gap.
That gap must be addressed before the financing plan is complete.
Possible solutions depend on the transaction and could involve adjusting the structure, increasing equity, modifying the project scope, bringing in another capital source, or pursuing another appropriate financing strategy.
Step 5: Evaluate the Exit Strategy
The capital stack should also make sense at the end of the investment period.
Short-term financing, for example, requires a realistic path to repayment.
That could involve selling the property, refinancing after stabilization, completing a redevelopment plan, or another transaction-specific exit.
The important point is that the exit should be considered when the capital stack is created, not after financing has already been selected.
Example: Structuring a $2.5 Million Mixed-Use Project
Consider an investor evaluating the purchase of a mixed-use property for $2 million.
The property includes residential units above ground-floor commercial space. The investor plans to renovate several units, improve common areas, complete work on the retail space, and stabilize occupancy.
The purchase price alone does not represent the investor’s complete financing requirement.
Assume the investor develops the following project budget:
- Purchase price: $2,000,000
- Renovation and improvements: $300,000
- Closing and professional costs: $75,000
- Carrying costs and reserves: $125,000
The total estimated capital requirement is $2.5 million.
If the investor focuses only on shopping for an acquisition loan, they may compare several financing options based primarily on the $2 million purchase.
But that leaves an important question unanswered:
Where will the capital for the remaining project costs come from?
Suppose the investor plans to contribute $600,000 of their own capital and obtains $1.6 million in financing.
Together, those sources provide $2.2 million.
The project still has a $300,000 financing gap.
At that point, the issue is no longer simply finding a better acquisition loan. The investor needs to reconsider the capital structure.
They might evaluate whether additional equity is appropriate, whether another financing structure better matches the project, whether the project budget should change, or whether another source of capital belongs in the stack.
The final structure would depend on the actual transaction and available financing options.
This example illustrates why capital stack planning should begin with the full project budget.
A loan can work exactly as intended and the transaction can still be undercapitalized if the rest of the stack has not been planned.
Common Capital Stack and Loan Shopping Mistakes
1. Focusing Only on the Interest Rate
Rate matters, but it is only one part of a financing decision.
Investors also need to evaluate the overall structure and how it fits the project.
A financing option that appears attractive based on one term may not necessarily be the best fit for the complete transaction.
2. Treating Maximum Leverage as the Goal
More leverage can reduce the amount of equity required upfront, but it can also increase debt obligations and reduce flexibility.
The appropriate amount of leverage depends on the transaction and investment strategy.
The goal should be a workable capital structure, not simply the largest possible loan.
3. Ignoring Costs Beyond the Purchase Price
Acquisition price is only one component of many real estate projects.
Renovation costs, reserves, carrying costs, closing expenses, tenant improvements, and other expenses can materially affect the total capital requirement.
Failing to account for those costs can create a financing gap later.
4. Waiting Too Long to Identify a Financing Gap
Investors sometimes discover a gap only after the financing process is already underway.
That can force them to search for additional capital when transaction deadlines are approaching.
Building a complete sources-and-uses picture earlier can make potential gaps easier to identify.
5. Ignoring the Exit Strategy
A financing structure should connect to the expected exit.
If short-term financing is being used, the investor should understand how the debt is expected to be repaid.
The financing plan and the business plan should support each other.
6. Comparing Financing Options Before Defining the Need
It is difficult to determine which financing structure fits a deal when the actual capital requirement has not been clearly defined.
Before comparing options, investors should understand what the capital needs to accomplish.
7. Assuming Every Deal Needs a Complex Capital Stack
Capital stack design does not mean making every transaction complicated.
Some properties can be financed effectively with a relatively simple combination of debt and equity.
The objective is not complexity.
The objective is alignment between the capital structure and the transaction.
The Better Question Is How the Entire Deal Should Be Financed
Loan shopping and capital stack design are related, but they solve different problems.
Loan shopping asks:
Which financing option should I choose?
Capital stack design asks:
How should the entire transaction be financed?
For a straightforward acquisition, those questions may lead to a similar answer.
For redevelopment, value-add, mixed-use, multifamily, commercial, and other more complex transactions, the distinction can become much more important.
Investors need to understand the total capital requirement, available equity, role of debt, potential financing gaps, liquidity needs, and exit strategy.
The individual loan is one piece of that larger structure.
eFunder Capital helps real estate investors, property owners, developers, and appropriate commercial borrowers evaluate financing needs, consider potential structures, and execute real estate financing based on the circumstances of the transaction.
If you know you need financing but are still determining the right structure or capital stack, request a Financing Review here: https://apply.efundercapital.com/financing-review
