Capital Stack – CRE Deal Financial Structure

The capital stack represents a commercial real estate deal’s financial structure.  It determines the investor’s returns and degree of risk they take on – who is first in line for repayment. 

Senior Debt

Senior debt is the bottom layer of the capital stack, often provided by a commercial bank.  Senior debt is typically the largest portion of the capital stack and earns the lowest interest (return) due to it being the least risky.  This is because senior debt is first in line for repayment.

Mezzanine Debt

Mezzanine financing falls in the middle of the capital stack, which means that payment priority is only subordinate to the senior debt and before the equity layers.  Mezzanine debt will typically be paid regular payments at a stated rate, which is higher than the senior debt rate due to the increased risk.  Mezzanine lenders may have foreclosure rights, typically governed by the terms of the agreement, if the borrower defaults.  However, mezzanine debt is not always an option, as some senior debt providers may restrict the use.

Preferred Equity

Preferred equity is the layer in the capital stack just below common equity, meaning that payment priority is only subordinate to debt but comes before common equity.  There’s a significant amount of flexibility in how preferred equity can be structure, but typically investors receive a preferred return that must be paid; therefore, providing more certainty than the common equity layer.  This layer is often described as “hard pay” or “soft pay”.  A “hard pay” structure typically requires that the preferred return must be paid regardless of property cashflow, whereas “soft pay" typically only requires payments if there is sufficient cashflow and will accrue the preferred return.

Common Equity

Common equity is the top layer of the capital stack, typically consisting of general partner and limited partner equity.  Common equity investors take on the most risk and are only paid after all the other parties in the capital stack receive their funds; however, they also have the greatest upside if an investment thrives as they have rights to all the remaining income.  Therefore, in the event that an investment is largely successful, common equity investors could realize sizable returns.