The capital stack is a useful way to represent a commercial real estate deal’s financial structure and the balance between different types of capital used to finance a property.

A commercial real estate property’s capital stack can be critical in determining the investor’s returns and the degree of risk they could take on.

What is the capital stack in real estate?

The types of capital in the capital stack can be broken into two main components: debt and equity. Each can be divided into layers representing different types of debt and equity an investor might use.  

The order of the capital stack’s layers corresponds to each type of capital’s payment priority. Not all deals will use every layer of the capital stack.

Senior debt

The bottom layer of the capital stack is senior debt, or mortgage financing that’s often provided by a commercial bank. Senior debt typically earns the lowest interest rate, or return, in the capital stack because it comes with the lowest risk. That’s because debt obligations are paid first, and the lender has the ability to take possession of the asset if the borrower defaults.

Mezzanine debt

As its name suggests, mezzanine financing falls in the middle of the capital stack, both in priority of payment and risk to the lender. Mezzanine lenders, which can include real estate funds, life insurance companies and individuals, typically have the right to take possession of the borrower’s equity in the property if the borrower defaults—but not the asset itself. Mezzanine lenders are generally seen as above equity investors in position for payments, but behind the mortgage lender.

A mezzanine lender’s interest rate is typically higher than a mortgage lender’s because the mezzanine lender accepts more risk.

However, mezzanine debt is not always an option, as mortgage lenders may restrict the use of mezzanine debt.

Preferred equity

Preferred equity investors share in the ownership of a commercial property and only earn returns after the property’s debt obligations are covered. But preferred equity investors are typically promised a minimum return before investors in the final capital stack layer are paid. There are a wide variety of sources of preferred equity, including individuals and families, private equity funds and institutional investors.

Common equity

Common equity is typically held by a commercial real estate deal’s sponsor, or the investor or team behind the deal. Common equity investors accept the most risk; they’re only paid after all other parties in the capital stack receive their entitled funds. Common equity investors also have the greatest upside if an investment thrives, because they have rights to all income left after everyone else gets paid. 

Capital stack examples

Real estate investments may not involve all four layers of the capital stack.

If an investor secures a multifamily loan covering 55% of an apartment building’s acquisition price and has enough capital to cover the remaining 45%, their capital stack would include only senior debt and common equity.

Let’s say the investor only has enough capital to cover 30% of the building’s price, or they prefer to diversify and spread their capital across multiple properties. Now the investor needs to add layers to the capital stack to close the capital gap needed to finance the deal. If the investor chooses to seek equity from other investors, their capital stack might include 55% senior debt, 15% preferred equity and 30% common equity.   

Building an optimal capital stack

The structure of a commercial real estate investor’s capital stack influences the project’s profitability and level of control the investor has over the asset.

Finding the right structure requires evaluating the investor’s available capital sources, comparing the cost of capital and assessing the impact on expected returns. But cost isn’t the only factor. 

It’s also important to consider the overall balance of debt and equity. Adding debt to a capital stack—for instance, by filling a gap in funding with a mezzanine loan, when possible—has the potential to amplify returns to equity investors through leverage. But large debt obligations can create challenges if the property fails to generate the expected cash flow.

Adding equity to the capital stack reduces debt obligations, preserving cash flow. But that means the lead investor must either put more of their own equity into the deal or bring in new investors, from individuals who are part of their personal or professional network to larger, institutional players. That could potentially reduce their control over the asset.

What the best version of the capital stack looks like will vary from one commercial real estate investor to the next, and one property to the next. Carefully evaluating the mix of capital sources is a key part of planning any new investment.