The capital stack represents all financing layers in a commercial real estate transaction, from senior debt to equity. Understanding this structure is essential for analyzing returns and risk in any commercial deal.
Senior Debt: Foundation of the Stack
First position loans from banks or CMBS (Commercial Mortgage-Backed Securities). Lowest risk, lowest return (4-7% rates). Typically 60-70% of total capital. First claim on property and cash flow. Safest but most restrictive—covenants limit operational flexibility.
Mezzanine Debt: Middle Ground
Second position debt filling gap between senior debt and equity. Higher risk than senior debt, lower than equity. Returns of 10-14%. Subordinate to senior debt but senior to equity. Quicker foreclosure rights than senior lenders through UCC filing on borrower entity interests.
Preferred Equity: Almost Equity
Senior to common equity but junior to all debt. Target returns of 12-16%. Receives specified return before common equity distributions. Converts to common equity if return thresholds unmet. Provides downside protection while participating in upside.
Common Equity: Highest Risk/Return
Last claim on cash flow and sale proceeds but unlimited upside. Target returns of 18-25%+. Sponsors typically contribute 5-20% of common equity. Receives profits after all debt service and preferred returns paid. Most vulnerable to loss but captures majority of appreciation upside.