What Is the Capital Stack?
Nearly every commercial real estate acquisition or development is financed with more than one type of capital. The capital stack describes how those different sources of debt and equity are layered together to fund a single deal, and — critically — the order in which each layer is entitled to be repaid from the property's cash flow and, ultimately, from sale or refinancing proceeds.
Each layer carries a different level of risk and, correspondingly, a different expected return. Layers with a first claim on repayment (like a senior mortgage) accept a lower return in exchange for greater safety, while layers with only a residual claim (like common equity) demand a much higher return because they are first to absorb any shortfall or loss.
The Four Core Layers
Most capital stacks are built from some combination of four layers, from most senior to most junior: senior debt, mezzanine debt, preferred equity, and common equity. Senior debt is typically a first-lien mortgage provided by a bank, agency lender, life insurance company, or CMBS conduit, and it is repaid before any other capital source. Mezzanine debt and preferred equity occupy the middle of the stack, filling the gap between what senior debt will lend and the total capital the deal requires. Common equity — contributed by the sponsor and its investors — sits at the very bottom, absorbing losses first but also capturing the greatest share of the upside if the deal outperforms.
Not every deal uses all four layers. A simple, lower-leverage acquisition might be financed with just senior debt and common equity, while a larger or more aggressive deal may add mezzanine debt or preferred equity to boost leverage without diluting the sponsor's ownership further.
Why Position in the Stack Matters
A capital source's position in the stack determines both its priority of payment and its priority of loss absorption. Cash flow is generally distributed starting with debt service on senior debt, then any mezzanine or preferred payments, with common equity receiving whatever residual cash flow remains. If the property underperforms, losses flow in the opposite direction — common equity is impaired first, then preferred equity and mezzanine debt, with senior debt the last layer to take a loss.
This relationship is why the capital stack is often pictured as a vertical stack of blocks: the further down a layer sits, the smaller and riskier its cushion, and the higher the return it must offer to compensate.
Blending Capital Sources to Fit the Deal
Sponsors and originators build a capital stack to match the specific needs of a transaction — maximizing leverage and equity returns while keeping overall cost of capital and risk in balance. A well-structured stack matches each capital source to the risk it is actually being asked to take, for example using mezzanine debt or preferred equity to bridge the gap between a conservative senior loan amount and the total capital needed, rather than relying on a single lender to overextend on leverage.
Understanding how these layers interact is foundational to nearly every other topic in CRE finance, from how loans are sized against a project to how profits are ultimately split among the equity investors and the sponsor.
Factors That Shape a Deal's Capital Stack
- The sponsor's available equity and appetite for ownership dilution
- The senior lender's maximum loan-to-value (LTV) and minimum debt yield or DSCR requirements
- The property's stability and cash flow — stabilized assets typically support more leverage than transitional or development deals
- The cost and availability of subordinate capital, such as mezzanine debt or preferred equity
- Market conditions, including interest rates and investor return expectations
Capital Stack Layers by Seniority
| Layer | Typical Position | Risk Level | Target Return Band (Illustrative) |
|---|---|---|---|
| Senior Debt | First lien on the property; repaid first from cash flow and sale proceeds | Lowest | Often roughly 5%-8% interest rate |
| Mezzanine Debt | Subordinate to senior debt, senior to preferred and common equity | Moderate-High | Often roughly 9%-14% |
| Preferred Equity | Senior to common equity, junior to all debt | Moderate-High | Often roughly 8%-13% |
| Common Equity | Residual, most junior claim; last paid, first to absorb losses | Highest | Often targets 15%+ IRR |
Risk and Return Move Together
As you move down the capital stack from senior debt toward common equity, priority of repayment decreases while potential return increases. Layers absorb losses in reverse order of seniority — common equity takes the first loss, and senior debt is typically the last layer affected.
Module Check
In the commercial real estate capital stack, which layer is repaid first in the event of a sale or refinancing?