Every commercial real estate deal is financed through a combination of debt and equity. The capital stack is the term used to describe how all of those financial instruments are layered together, who gets paid first, and what each position's risk and return profile looks like.
Understanding the capital stack is foundational for any passive investor. Where your capital sits in the structure determines how much risk you're taking on, how you get paid, and what happens to your investment if the deal runs into trouble.
The Structure
A simple capital stack might involve just two layers: senior debt covering 70 to 80 percent of the acquisition price, with common equity making up the remainder. A more complex structure, sometimes called a full stack, can include senior debt, mezzanine debt, preferred equity, and common equity. Each layer has a defined position, a defined priority of payment, and a corresponding risk and return profile.
The general rule across all structures is straightforward. The lower your position in the stack, the safer your capital but the lower your return. The higher your position, the more risk you carry but the more upside you have access to.
Senior Debt
Senior debt is the most risk-averse position in the capital stack. Senior lenders, such as Fannie Mae, Freddie Mac, or institutional banks, typically lend up to 70 to 80 percent of the property's value. Because they sit in first position, they have first priority on all payments and first claim on the asset in the event of a default. That protection is why they accept the lowest return in the structure. In the case of borrower default, the senior lender takes over the operating position of the asset and initiates the foreclosure process.
Mezzanine Debt
Mezzanine debt sits behind senior debt in payment priority and bridges the gap between the senior loan and the equity portion of the deal. It typically covers 5 to 20 percent of the property's value or cost. Because it is subordinate to the senior lender but senior to all equity, mezzanine debt carries more risk than senior debt but less than equity. Returns are capped relative to equity but higher than the senior position. Mezzanine debt is typically shorter term and is used when the senior loan alone does not cover enough of the capital requirement.
Preferred Equity
Preferred equity sits below mezzanine debt in priority but above common equity. It offers more flexibility than mezzanine in terms of structure and can be configured with a fixed rate of return, upside participation, or both. A common structure provides investors a preferred rate of return, such as 8 percent, before any profits are split with the general partner through the waterfall. Because of its priority over common equity, preferred equity carries less risk than common equity but typically has a ceiling on its upside.
Common Equity
Common equity sits at the top of the capital stack and carries the most risk in the structure. It is subordinate to every other tranche, which means it is the last to be repaid and the first to absorb losses if the deal underperforms. In exchange for that risk, common equity has the highest upside potential.
In most private real estate deals, common equity investors receive a preferred rate of return with a hurdle, often around 8 percent, before profits are split. Once that hurdle is reached, the general partner receives a disproportionate share of the remaining profits, known as the sponsor's promote. This structure is designed to align the operator's incentives with investor returns.
Not all common equity positions carry the same risk. A well-structured preferred return within the common equity layer can provide meaningful downside protection even at the top of the stack.
The Bottom Line
How the capital stack is structured on any given deal tells you a great deal about how risk is distributed and who is protected when things get difficult. A deal with conservative senior leverage, a clean equity structure, and a sponsor co-investing meaningful capital alongside LPs is structured very differently from a deal that is maximally levered with a thin equity cushion.
As a passive investor, the capital stack is one of the first things worth understanding when evaluating any opportunity. The returns shown in a summary tell you what the upside looks like. The capital structure tells you what the downside looks like.
When credit markets tighten, as they did through the 2022 to 2024 rate cycle, opportunities shift across the stack. Equity positions that were priced aggressively during low-rate environments reprice, and investors who understand the structure can identify where the best risk-adjusted entry points are in the current cycle.
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