The Capital Stack Explained

Every commercial deal is funded by a stack of capital. At the bottom is the safest, cheapest money. At the top is the riskiest, most expensive money. Between them sit several layers, each with its own returns, rights, and recourse. Understanding the capital stack is the foundation of all CRE financing.

This lesson introduces the structure. The remaining lessons cover each layer in depth.

Why a "stack"?

Because the layers have an order. If a deal goes bad and the property is sold for less than what's owed, the layers get paid back in priority — top to bottom is where they sit visually, but bottom-to-top is the order of risk and return:

| Layer (top → bottom) | Typical % of stack | Return / cost | Risk | Payback priority | |---|---|---|---|---| | Common equity (sponsor + LPs) | 20–35% | 15–25%+ IRR target | Highest — first to lose | Last paid | | Preferred equity | 5–15% | 8–12% pref + kicker | High | 4th paid | | Mezzanine debt | 5–15% | 10–14% interest | Medium-high | 3rd paid | | Senior debt | 60–75% | 5–8% interest | Lowest | First paid (1st lien) |

The senior debt is at the bottom of the stack but at the top of the payback line. If the deal goes south, senior debt gets paid back first, then mezz, then preferred equity, then common equity (which is the first to lose money and the last to recover).

Senior debt — the foundation

Senior debt is the largest single piece of most CRE deals — typically 60-75% of the purchase price.

Characteristics

• Largest piece — $3M loan on a $4M property is typical
• Lowest cost — 5-8% interest in a normal rate environment
• First-position lien — secured by the property itself
• First in line for repayment in default
• Strict requirements — DSCR, debt yield, LTV, borrower covenants
• Long term — 5, 7, 10, or 25 years depending on loan type

Sources

• Conventional banks (community, regional, national)
• SBA 504 and 7(a)
• Life insurance companies
• Agency lenders (Fannie Mae, Freddie Mac — multifamily only)
• CMBS conduits
• Bridge lenders (short-term)
• Hard money lenders (very short-term, high-rate)

Each type has its own niche. We'll cover each in detail in the next lessons.

Mezzanine debt — the middle layer

Mezzanine debt sits between senior debt and equity. It's used when the senior loan doesn't cover enough of the price and the sponsor wants to reduce the equity check.

Characteristics

• Smaller piece — typically 5-15% of total capitalization
• Higher cost — 10-14% interest, sometimes with PIK (payment-in-kind) or current pay
• Second-position security — usually secured by a pledge of the equity in the property's owning LLC, not by the property itself (because the senior lender already has the first lien on the property)
• Junior to senior debt in payback
• Senior to all equity in payback
• Usually shorter term than senior debt
• Has its own covenants and intercreditor agreements

When to use it

• The deal needs more leverage than senior debt alone provides
• The sponsor doesn't want to (or can't) raise more equity
• Cash flow can support the additional interest
• Returns to common equity work even after paying mezz interest

Example

• Purchase price: $10M
• Senior loan: $6M (60% LTV, 6% interest)
• Mezz: $1.5M (15%, at 12% interest)
• Equity: $2.5M (25%)

Without mezz, the equity check would be $4M. The mezz reduces equity by $1.5M but adds $180K/year of interest expense. Whether it's worth it depends on whether the sponsor can earn more than 12% on the freed-up $1.5M of capital somewhere else.

Preferred equity — the equity-debt hybrid

Preferred equity sits between mezz debt and common equity. It's structured as equity but behaves like debt.

Characteristics

• Equity in legal form — preferred equity holders are members of the LLC, not lenders
• Fixed return — typically 8-12% preferred return, paid before common equity gets anything
• Possible upside participation — some deals give preferred equity a "kicker" of additional returns above a hurdle
• Junior to all debt in default
• Senior to common equity in distributions
• No collateral — relies on the LLC's economics
• Sometimes redeemable at a specific date

When it's used

• The sponsor needs more leverage than senior + mezz allows
• The sponsor wants debt-like cost but can't (or doesn't want to) take on more debt
• Common equity investors want a "promote" structure that aligns sponsor incentives

Preferred equity is most common in larger deals and value-add or development plays where the all-in capital need exceeds what debt can provide.

Common equity — the riskiest, most rewarding

Common equity is at the top of the stack — last to be paid back, first to lose. In return, common equity gets all the upside above the contracted returns of the debt and preferred layers.

Characteristics

• Smallest layer in $ terms but largest in % of returns when the deal works
• No fixed return — earns whatever the deal produces above debt service and preferred returns
• Highest risk — first to lose if values decline
• Highest target return — 15-25%+ IRR depending on risk
• Two sub-layers usually:
  • GP / sponsor equity — small dollar amount, large percentage of upside via the "promote"
  • LP / passive investor equity — most of the dollar amount, modest share of upside

We'll cover the GP/LP structure and waterfalls in the syndication course (Course 19).

How the layers interact

Some interactions to understand:

Intercreditor agreements

When you have senior + mezz, the senior lender and mezz lender sign an intercreditor agreement defining their relationship — who gets paid when, who can foreclose, what happens in default. Senior lenders typically require veto rights over the mezz lender's actions.

Cash flow waterfall

Cash from operations is distributed in this order:

1. Operating expenses (paid first)
2. Senior debt service (interest + principal)
3. Mezz debt service
4. Preferred equity return (current pay)
5. Common equity distributions

If the property doesn't generate enough cash to reach a layer, that layer doesn't get paid that month.

Distribution waterfall (sale)

When the property is sold:

1. Repay senior debt in full (with prepayment penalty if applicable)
2. Repay mezz in full
3. Pay accrued preferred equity returns and return preferred equity capital
4. Return common equity capital (LP first, then GP)
5. Split remaining proceeds via the promote structure (typically 70/30 LP/GP up to a hurdle, then 50/50 above)

Default cascade

If the deal defaults:

1. Senior lender forecloses on the property → wipes out everything below senior debt (junior debt, all equity)
2. If the foreclosure sale covers senior debt fully, mezz lender may step in via their pledge of the equity → mezz lender becomes the new owner via the LLC equity
3. Preferred and common equity lose their entire investment

This cascade is why the equity check is the most at-risk capital. It's also why equity demands the highest returns when the deal works.

Why the stack matters for sponsors

Building the right capital stack for a deal is one of the most consequential decisions a sponsor makes. The right stack:

• Maximizes returns to common equity (the sponsor's investors)
• Maintains acceptable risk
• Survives realistic downside scenarios
• Avoids restrictive covenants that limit operating flexibility
• Provides the right liquidity when needed (refinance, sale, recapitalization)

The wrong stack:

• Boxes in the sponsor with covenants
• Creates default risk in mild downside scenarios
• Saddles the deal with prepayment penalties that prevent flexibility
• Mismatches capital cost and asset risk
• Alienates investors with bad terms

A simple stack vs a complex stack

Small deal — simple stack

A $2M MF property bought by a single investor:

• Senior loan: $1.4M (70% LTV, conventional bank, 7% rate, 25-year amort)
• Equity: $600K (sponsor cash)

That's it. Two layers. No mezz, no preferred, no LPs. This is how most small deals get done — and how most beginners should start.

Mid deal — typical syndication

A $10M industrial property bought by a sponsor with passive investors:

• Senior loan: $6.5M (65% LTV, life co loan, 6% rate, 10-year term)
• Common equity: $3.5M (sponsor + LPs split via promote structure)

Two layers, but the equity is split between active sponsor and passive LPs.

Large deal — institutional stack

A $50M Class A multifamily property:

• Senior loan: $32.5M (65% LTV, agency debt, 5.5% rate, 10-year I/O)
• Mezz: $5M (10% of total, 11% rate)
• Preferred equity: $5M (10% pref, 8% return)
• Common equity: $7.5M (sponsor 10%, LPs 90%)

Four layers, each with its own intercreditor and cap stack agreements. This is the institutional norm for larger deals.

Why beginners should keep it simple

In your first 5-10 deals, stick to:

• Conventional or SBA senior debt
• Common equity from yourself and small partners
• No mezz, no preferred equity, no complex waterfalls

The marginal returns from a complex stack rarely justify the complexity, the cost (legal, structuring), and the risk (more layers = more ways to fail). Walk before you run.

The exception: if your deal needs SBA 504 (which has a built-in two-loan structure), you'll learn that complexity in Lesson 3.

What to take away

• Every CRE deal is funded by a stack of layers, from senior debt at the bottom to common equity at the top
• Senior debt is the largest piece, lowest cost, first to be paid back, first lien on the property
• Mezz debt is junior to senior, secured by equity pledge, higher rate
• Preferred equity is between mezz and common, gets a fixed return before common
• Common equity is at the top — riskiest, but receives all upside above the debt and preferred returns
• Understanding the stack lets you compare deals and structures, not just rates
• Most beginner deals are just senior debt + common equity — simple stacks work for small deals
• Complex stacks are for large institutional deals where the marginal benefit exceeds the marginal complexity

Next lesson: conventional commercial bank loans — the most common form of senior debt for first-time and small CRE buyers.