First-Loss Position 2020-12-31 08:00:00

First-Loss Position

First loss position is an investment’s or security’s position that will suffer the first economic loss if the underlying assets lose value or are foreclosed upon. In the context of commercial real estate, the first-loss position typically refers to the equity position of an investment.  For instance, if an investment property is acquired for $1,000,000 by utilizing $250,000 of equity and $750,000 of debt and the property is later sold for $900,000, then the sales proceeds would first be used to repay the loan, and any remaining funds would then belong to the equity investor.

In this example, the $900,000 sales proceeds would fully repay the $750,000 debt, but would only return $150,000 to the equity investor - meaning the equity investor would suffer the first losses. The debt position, by contrast, would not suffer a loss unless the sales proceeds dropped below $750,000. The first-loss position carries a higher risk and, generally, the potential for higher yield.

A first-loss position is only one of many positions within the capital stack. The capital stack is a hierarchical arrangement of funds used to finance a project. As mentioned above, funds are split across debt and equity. Debt is borrowed money that must be paid back, while equity is contributed by investors and owners. The configuration of debt and equity within a project can change. For example, a lower risk project might have an 80% debt and 20% equity structure, while a more risky project may require a 50/50 configuration.

Besides debt and equity, the capital stack may include mezzanine debt. It sits between debt and equity but still falls within a hierarchy. Mezzanine debt can be used to finance higher-risk projects. There is also preferred equity that sits within the equity block. 

What do these other components of the capital stack have to do with first-position loss? As equity is split into different types of equity, such as common and preferred, the first-loss position may change or take on a new name. Instead of saying that equity is the first-loss position, now we say that common equity is the first-loss position, with preferred equity being second. Not all deals will have a capital stack with several components. Some may stay with just the traditional two components — debt and equity.

Equity is in the first-loss position because equity holders are able to participate in more upside than debt holders, who are restricted to fixed coupon payments. Equity holders have the potential for higher returns but must also assume the highest risk.

 


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