Most CRE deals are financed with two layers: senior debt and common equity. But for larger deals, value-add plays, and situations where the senior loan doesn't cover enough of the price, you need additional layers between senior debt and common equity. Mezzanine debt and preferred equity fill this gap.

This final lesson covers when to use each, how they're structured, what they cost, and how to put together a complete capital stack.

The leverage problem these layers solve

A typical conventional senior loan covers 65-75% of the purchase price. The remaining 25-35% has to come from somewhere — and that somewhere is usually common equity from the sponsor and investors.

For a $10M deal:

Senior loan: $7M
Equity needed: $3M

Most sponsors don't want to write a $3M check (or raise it from LPs at high cost). Mezz and preferred equity reduce the common equity check by adding leverage above the senior loan.

Without mezz:                With mezz:
┌──────────────────────┐    ┌──────────────────────┐
│ Common equity  $3.0M │    │ Common equity  $1.5M │  ← reduced by $1.5M
├──────────────────────┤    ├──────────────────────┤
│                      │    │ Mezz debt      $1.5M │  ← new layer
│ Senior debt    $7.0M │    │ Senior debt    $7.0M │
└──────────────────────┘    └──────────────────────┘

The trade-off: mezz costs more than senior debt (10-14% vs 6-7%) but less than common equity (which targets 15-25%+ IRR). When the deal generates positive leverage at the mezz rate, common equity returns improve significantly.

Mezzanine debt — the bridge between senior and equity

How mezz is structured

Mezz is technically debt, but it's not secured by the property itself (the senior lender already holds that lien). Instead, mezz is secured by a pledge of the membership interests in the property-owning LLC.

If the borrower defaults on the mezz, the mezz lender forecloses on the LLC interests — meaning they take ownership of the LLC, which owns the property. The senior loan stays in place; the mezz lender becomes the new owner subject to the senior debt.

This structure exists because senior lenders won't allow second-position liens on the property itself (which would interfere with their first-priority foreclosure rights). The equity pledge creates a workaround.

Typical mezz terms

| Feature | Common range | |---|---| | Loan size | 5-15% of total cap | | Rate | 10-14% | | Interest type | Current pay, PIK (payment in kind), or hybrid | | Term | Same as senior or shorter | | Recourse | Sometimes partial; sometimes non-recourse | | Origination fee | 1-2% | | Exit fee | 0.5-1% | | Intercreditor agreement | Required with senior lender |

Current pay vs PIK

Two interest payment styles:

Current pay — borrower pays interest monthly in cash from operations. Reduces cash flow available for common equity but doesn't grow the loan balance.
PIK (payment in kind) — interest accrues to the loan balance instead of being paid in cash. Loan balance grows over time. Common equity gets more cash flow now but owes more later.
Hybrid — some current pay (e.g., 6%) and some PIK (e.g., 6%) totaling the full interest rate.

PIK is useful for value-add deals where current cash flow is low. Current pay is appropriate for stabilized deals where cash flow can support it.

Intercreditor agreements

When you have senior + mezz, the senior and mezz lenders sign an intercreditor agreement (ICA) defining their relationship:

Who controls foreclosure
What happens in default
Standstill periods (mezz can't foreclose for X days while senior cures)
Notice and cure rights
Limits on the mezz lender's ability to interfere with senior

ICAs are heavily negotiated. Senior lenders generally want maximum control; mezz lenders want maximum protection. The ICA terms affect how the deal behaves in distress.

When to use mezz

✓ Senior loan doesn't provide enough leverage ✓ Sponsor wants to reduce common equity check ✓ Cash flow can support the higher debt service ✓ Common equity returns improve enough to justify the cost ✓ Senior lender allows mezz behind them (not all do) ✓ Stress-tested downside still works with the additional debt

When NOT to use mezz

✗ Cash flow is tight ✗ Senior lender prohibits mezz ✗ The marginal IRR improvement is small ✗ Adds material default risk in downside scenarios ✗ Beginner deal — additional complexity not worth it

Preferred equity — the equity-debt hybrid

Preferred equity is structured as equity (not debt) but behaves like debt — fixed return, payment priority over common equity, sometimes a put right (forced exit at a specific date).

How preferred equity is structured

Pref equity holders are members of the LLC, not lenders. They contribute capital alongside common equity but have a preferred position in distributions:

They receive a "preferred return" before any cash flows to common equity
They get their capital back before common equity gets its capital back
Sometimes they get an additional "kicker" of upside above the preferred return

Typical pref equity terms

| Feature | Common range | |---|---| | Size | 5-15% of total cap | | Preferred return | 8-12% | | Pay style | Current pay, accrued, or hybrid | | Term | Often "redeemable" at year 5-7 | | Position | Junior to all debt, senior to common equity | | Upside participation | Sometimes; not always | | Control rights | Limited; sometimes major-decision votes |

Pref equity vs mezz — what's the difference?

The legal form is different (equity vs debt) and that affects:

| Factor | Mezz | Pref Equity | |---|---|---| | Legal form | Debt | Equity | | Lender / member | Lender | LLC member | | Tax treatment | Interest deductible | Distributions, not deductible | | Foreclosure mechanism | Equity pledge foreclosure | LLC operating agreement remedies | | Senior lender concerns | High (intercreditor) | Lower (no lien) | | Cost | 10-14% | 8-12% | | Flexibility | Lower | Higher |

The economic effect is similar — both add leverage between senior and common — but the legal mechanics differ. Senior lenders typically prefer pref equity over mezz because there's no lien risk.

When to use pref equity

✓ Senior lender prohibits mezz but allows pref equity ✓ Sponsor wants a debt-like cost without legal debt structure ✓ The deal has equity-like risk (value-add, development) where pref equity holders accept some operational risk ✓ Sponsor wants flexibility in distribution waterfall

Why some deals use both mezz AND pref equity

For very large deals with sophisticated sponsors:

Senior debt: 60% of stack (lowest cost)
Mezz debt: 10% of stack (lower cost than pref)
Preferred equity: 10% of stack (between mezz and common)
Common equity: 20% of stack (highest cost, highest return)

Each layer is sized to optimize the cost of capital and the return to common equity. This is institutional-grade capital stacking.

For most beginners and small deals, this is overkill. Stick with senior + common equity.

Building a capital stack — a worked example

Let's build a stack for a $15M Class A multifamily acquisition in Orlando.

Property fundamentals

Purchase price: $15,000,000
Stabilized NOI: $900,000
Cap rate: 6.0%
Sponsor target IRR: 18%

Option 1 — Simple stack (senior + equity)

Senior loan: $10,500,000 (70% LTV, agency, 5.75%, 10-year, 30-year amort)
Equity: $4,500,000

Annual debt service: ~$735K Cash flow after debt service: $900K - $735K = $165K Cash-on-cash return: $165K / $4.5M = 3.7%

Equity multiple over 10 years (assuming 3% annual NOI growth and exit at 6.0% cap): ~2.0x IRR: ~14.5%

That's below target. The deal works but doesn't hit the 18% target.

Option 2 — Adding mezz

Senior loan: $10,500,000 (70% LTV, agency, 5.75%)
Mezz: $1,500,000 (10%, 11% rate, current pay)
Equity: $3,000,000

Annual debt service: ~$735K (senior) + $165K (mezz) = $900K Cash flow after debt service: $900K - $900K = $0 Cash-on-cash return: 0%

The deal pencils to break-even on cash but has no margin. If anything goes wrong (vacancy, expense increase, rate movement), the deal can't service its debt.

The IRR improves because the equity check is smaller, but the risk is significantly higher. This stack only works if you're highly confident in the cash flow.

Option 3 — Adding pref equity

Senior loan: $10,500,000 (70% LTV, agency, 5.75%)
Pref equity: $1,500,000 (10%, 9% return, accrued)
Common equity: $3,000,000

Annual debt service: ~$735K (senior only) Cash flow after senior debt service: $900K - $735K = $165K Cash-on-cash to common equity (after pref accrual): variable depending on whether pref is accrued or current pay

If pref is accrued (not current pay), common equity gets the $165K of free cash flow as before. But at sale, pref equity gets paid back $1.5M plus all accrued returns ($1.5M × 9% × ~10 years = $1.35M accrued) before common equity gets anything.

The IRR profile improves vs Option 1 because the equity check is smaller AND current cash flow isn't reduced. But common equity's upside is partially capped.

Option 4 — Conservative simple stack with patient capital

Sometimes the right answer is to accept a lower IRR in exchange for lower risk:

Senior loan: $9,000,000 (60% LTV)
Equity: $6,000,000

Annual debt service: ~$630K Cash flow: $900K - $630K = $270K Cash-on-cash: $270K / $6M = 4.5% DSCR: 1.43x (very strong) IRR over 10 years: ~13%

This is a low-risk, modest-return profile. If you have patient capital and value sleep-at-night certainty, this beats the more leveraged options for actual risk-adjusted return.

Choosing the right stack

The right capital stack depends on:

Sponsor's risk tolerance — how much downside can you accept?
Investor expectations — what IRR have you promised LPs?
Asset risk profile — stable cash flow vs. uncertain cash flow
Hold period — short hold favors lower leverage; long hold can support more leverage
Refinance assumptions — can you refi at higher LTV later?
Tax considerations — debt interest is deductible; equity returns are not
Operational flexibility needs — restrictive lenders constrain decisions

There's no single right answer. The stack is a series of trade-offs.

Stress testing the stack

Before committing to any stack, stress test it:

Base case: hits target returns
Downside case: rents drop 10%, expenses up 15% — does the deal still service debt?
Severe downside: occupancy drops to 70%, NOI drops 30% — can the deal survive without default?
Rate shock: refinance at 200 bps higher — does the deal still pencil?

If any layer of the stack causes default in a realistic downside scenario, that layer is too risky for this deal. Restructure or remove it.

Leverage cost discipline

A useful exercise: calculate the all-in cost of capital across your stack.

Weighted average cost of capital (WACC):

WACC = (Senior% × Senior rate) + (Mezz% × Mezz rate) + (Pref% × Pref rate) + (CE% × CE return)

For Option 2 above:

Senior: 70% × 5.75% = 4.0%
Mezz: 10% × 11% = 1.1%
Equity: 20% × 18% = 3.6%
WACC: 8.7%

If your unlevered yield (NOI / total cap) is below your WACC, you're losing money on a leveraged basis. For this deal: $900K / $15M = 6.0% unlevered yield. WACC of 8.7% means you're underwater on a true risk-adjusted basis — the deal needs appreciation to work, not just cash flow.

This is the discipline that separates good sponsors from bad: understanding that adding leverage doesn't create returns, it just amplifies them. If the underlying asset doesn't produce returns above the cost of capital, no amount of leverage will save it.

What to take away

Senior + common equity is the simplest stack and works for most small deals
Mezz debt fills the gap between senior loan and equity, secured by LLC equity pledge
Mezz costs 10-14%, sized 5-15% of total cap, requires intercreditor with senior
Pref equity is structured as equity but behaves like debt — fixed return, priority over common
Pref equity is often preferred by senior lenders over mezz (no lien interference)
Adding leverage improves returns when the asset yield exceeds the cost of new capital
Stress test every stack — leverage that fails in downside scenarios is too much leverage
WACC calculation reveals whether the deal economics support the chosen stack
Beginners should stick with senior + common equity; complex stacks come with experience

You've finished Course 11

You now understand the full menu of CRE financing options:

Conventional bank loans — the workhorse for most small and mid-size deals
SBA 504 and 7(a) — owner-occupant programs with low down payment
Bridge and hard money — short-term, value-add, distress
Agency debt (Fannie/Freddie) — the multifamily superpower
CMBS and life co — institutional non-recourse for $5M+
Mezz, preferred equity, and the full capital stack

Combined with your sourcing, analysis, and DD skills, you can now find a deal, analyze it, negotiate it, due-diligence it, finance it, and close it. You have the complete CRE acquisition skill set.

The next course is on the negotiating side: how to structure LOIs, work the negotiation process, identify your BATNA, and walk away with the right terms even when sellers and brokers push back.

Ready? Continue to Course 12: CRE Negotiations →

Mezz, Preferred Equity, and Building the Capital Stack