Capital Stack Organization In Commercial Real Estate Deals

Did you know that big banks hold about $860 billion in commercial real estate loans (just 6% of their assets), while smaller banks have a whopping $2 trillion tied up in these investments (30% of their assets)?

What these numbers show is how crucial proper capital stack organization in commercial real estate deals really is. From our experience, investors who understand the layers of financing in a project make smarter decisions and avoid costly mistakes.

Think of the capital stack as your project’s financial blueprint. It maps out who gets paid when and who takes on what risks.

This guide connects to our broader series on commercial real estate investment structures. If you’ve read our previous piece on tax implications of different commercial real estate structures, you’ll find this article builds nicely on those concepts.

Later, we’ll explore group real estate investment strategies that complement these financing structures.

Ready to boost your real estate know-how? By the end of this article, you’ll understand the four key components of any capital stack, recognize the risk-return tradeoffs at each level, and know exactly how to structure your next deal for maximum returns with manageable risk.

Let’s start!

Short Summary

• Capital stack organization in commercial real estate deals refers to how investment capital is layered, each with different risk and return levels.
• The main layers include senior debt, mezzanine debt, preferred equity, and common equity, ranked by payment priority.
• Risk decreases as you move up the stack, while potential returns increase as you move down.
• Optimizing the capital stack depends on property type, market conditions, investment goals, and tolerance for risk.
• A solid understanding of the capital stack can help investors structure smarter, more profitable deals.

The Fundamentals Of Capital Stack In Commercial Real Estate

Understanding the capital stack is like unlocking the blueprint behind how commercial real estate transactions are funded; and more importantly, how returns are distributed.

If you’ve ever wondered who gets paid first (and who gets paid last) when a deal makes money, or loses it, this is where it all starts. Below, we’ll walk through the core components of a real estate capital stack, how the hierarchy works, and how it can shape smarter decisions. 

What Is The Capital Stack?

The capital stack refers to the layers of capital that fund a commercial property deal. Each layer represents a different type of investment with its own return expectations, risk levels, and repayment terms.

Here’s the usual order from lowest to highest risk:

• Senior Debt
• Mezzanine Debt
• Preferred Equity
• Common Equity

Each layer comes with different obligations and payment priority. For example, senior debt, usually a bank loan or mortgage lender financing, is paid first and carries the lowest risk. Meanwhile, common equity sits at the bottom, where common equity investors only see returns after all other obligations are met.

Why Payment Priority Matters

The order of repayment isn’t just technical; it’s critical. It decides who gets repaid in a successful commercial real estate investment and who might take a hit during downturns.

Take a mixed-use project we modeled: senior loan covered 60% of the purchase price, and preferred equity holders got a fixed return before anything went to common equity holders. In that structure, returns to equity investors depended on outperforming projections.

That taught us that understanding the capital stack is vital before committing capital.

Risk And Reward By Layer

As a general rule:

• Senior lenders face less risk and accept lower expected returns
• Mezzanine lenders deal with subordinate debt, take more risk, and earn more
• Preferred equity investors get preferred returns, usually fixed and paid before profits
• Common equity holds the riskiest position, but the potential returns are highest

We once reviewed a mezzanine loan offering where the mezzanine debt filled a gap between the senior debt and preferred equity.

It looked appealing, but we realized the mezzanine financing terms meant if the borrower defaults, recovery might depend entirely on the underlying asset value.

 Visual Guide To The Capital Stack

Here’s how a typical capital stack in commercial real estate looks:

Capital Stack Breakdown

(Ranked by Risk & Payment Priority)

This simple structure helps investors match their risk tolerance to the right layer. From high-net-worth individuals to group real estate investment platforms, knowing where you sit in the capital stack organization in commercial real estate deals can make all the difference in your outcome.

Exploring Different Layers Of The Capital Stack Organization In Commercial Real Estate Deals

Understanding how each layer of the real estate capital stack works can make or break a deal. Each level (senior debt, mezzanine debt, preferred equity, and common equity) has its own set of expectations, responsibilities, and risk-return tradeoffs.

Let’s break them down, layer by layer, just like we would when planning a solid commercial real estate investment structure.

Senior Debt: The Foundation Of Most Deals

• Senior debt sits at the bottom of the risk ladder, which is exactly why it’s often the first layer secured in a commercial real estate transaction.
• Lowest Risk, First Paid: This is considered the lowest risk investment in the stack. In the event a borrower defaults, senior debt holders have first claim on the underlying asset.
• Who Lends It? Typically sourced from:
  • A bank loan
  • Credit unions
  • A mortgage lender
  • Or life insurance companies

• Terms to Know: Senior loans often cover up to 60–75% loan-to-value (LTV). They come with fixed interest rates, amortization schedules, and defined repayment terms.
• What Happens in Default? If the deal goes south, the senior lender can foreclose. The other layers get paid only after this group is made whole.

For instance, in a $20M commercial property deal, we might have $13M in senior debt, usually the “easiest” to secure, but also the most restrictive in terms of covenants.

Mezzanine Debt: Bridging The Gap

Sitting right above senior debt, mezzanine debt is a hybrid of debt obligations and equity financing.

• What Is It? A mezzanine loan fills the gap between senior debt and equity. It’s subordinate to senior but senior to equity.
• Typical Lenders:
  • Private mezzanine lenders
  • Real estate investment funds
  • Institutional investors

• Risk and Return: It carries more risk than senior but less risk than equity. That’s why it typically comes with higher interest rates or equity conversion options.
• Expected Returns: These vary but typically range between 10–15% annually.

Think of a scenario where the purchase price is $30M. You might have $18M in senior debt and another $5M in mezzanine financing to stretch leverage. That way, equity investors don’t have to inject as much upfront.

Preferred Equity: Fixed Returns, Flexible Rights

Preferred equity is an increasingly common tool used in today’s capital stack in commercial real estate deals. It sits above common equity, but below mezzanine debt in terms of repayment.

• What Is It? A form of equity investment that offers preferred returns, but often without collateral.
• Rights of Preferred Equity Holders:
  • Paid before common equity holders
  • Sometimes granted limited control rights in the deal

• Who Invests? Preferred equity investors can be:
  • Private equity firms
  • Family offices
  • Institutional capital pools

• Returns: Usually 8–12% annually, structured as a fixed preferred return before profits are split with other investors.

• Key Differences from Mezzanine Debt:
  • No foreclosure rights
  • Return depends more on cash flow and less on legal enforcement

We’ve seen deals where a sponsor adds $3M in preferred equity to limit dilution of common equity. It’s a creative capital tool when you want to boost returns without giving up control.

Common Equity: The Riskiest Position In The Stack

At the top of the capital stack, we find common equity, where risk meets reward. This is where commercial real estate investors either win big or walk away with nothing.

• Definition: Pure ownership in the deal, and the riskiest position in the structure.
• Who Invests?
  • Deal sponsors
  • Limited partners
  • Common equity investors looking for upside potential

• Potential Returns:
  • There’s no cap. Returns could be 15–25%+ annually, depending on performance.
  • On the flip side, they could be zero.

• Cash Flow Distribution:
  • After paying debt and preferred equity, any leftover cash flow is distributed to common equity holders.
  • Often structured through a “waterfall” where profits are split based on tiers of return.

Let’s say you’re structuring a $25M real estate deal. After securing debt and preferred equity, the remaining $4M might come from common equity. That’s the layer absorbing all the risk, but also reaping the biggest share if the project overperforms.

Each layer in the capital stack organization in commercial real estate deals comes with its own expectations. Structuring it right means getting everyone on the same page with their risk tolerance, what they expect to earn, and how long they plan to stick around.

Knowing the stack inside and out is how smart investors make more deals work, whether you’re using subordinate debt, equity, or both.

Risk-Return Relationships Across The Capital Stack

Every level of the capital stack comes with a different mix of risk and reward. Understanding how that balance shifts depending on your position can help investors choose where they feel most comfortable and confident putting their money.

Risk Tolerance And Return Expectations

Here’s how each layer stacks up in terms of risk tolerance and potential return:

• Senior Debt
  • Lowest risk
  • Typically offers 4–6% annual return
  • Ideal for conservative lenders and large institutions

• Mezzanine Debt
  • Moderate risk; takes a backseat to senior debt in repayment
  • Returns usually range from 10–15% annually
  • Attractive to funds seeking higher fixed income

• Preferred Equity
  • More risk than debt but still ahead of common equity
  • Targeted returns typically 8–12%
  • Works well for investors looking for passive income with some upside

• Common Equity
  • Highest risk and last in the repayment line
  • Returns can exceed 20%—if the project performs
  • Favored by limited partners and deal sponsors banking on appreciation

Real-World Example

Take a hypothetical $10M multifamily development. Let’s say:

• $6M is senior debt at 5%
• $2M is mezzanine debt at 12%
• $1M is preferred equity at 10%
• $1M is common equity, projected to return 22%

If the project underperforms, senior debt still gets paid. However, common equity could walk away with nothing.

Repayment Priority In Action

In strong markets, cash flow usually covers all layers. In a downturn, repayment priority follows the stack: debt first, equity last. Knowing how that works in different cycles helps investors plan exit strategies and stress-test their assumptions.

This is where capital stack organization in commercial real estate deals becomes more than just theory. It’s essential for managing expectations and avoiding surprises.

Strategic Capital Stack Structuring For Commercial Real Estate Investments

How you build your capital stack should reflect the deal’s unique profile. Smart structuring isn’t about copying templates. It’s more like matching capital to the deal’s specific risks, rewards, and timelines.

Here’s what to factor in:

• Property type and market conditions
  A stabilized office building in a strong metro might allow for more senior debt. But a ground-up development in an emerging area may lean on preferred equity or mezzanine debt to reduce upfront exposure.
• Purchase price and leverage goals
  If you score a solid asset at a discount, you might prioritize debt to amplify returns. But higher purchase prices might require more common equity to keep loan-to-value ratios conservative.
• Investment goals and risk tolerance
  Long-term hold with steady cash flow? Go heavier on debt. High-growth upside with value-add? Allow more room for common equity and preferred equity to absorb short-term volatility.

Balancing debt and equity is about staying nimble and managing both return expectations and lender demands.

Capital Stack Organization In Practice

Let’s walk through what a structured capital stack could look like on a real deal. Hypothetically, of course. Say we’re analyzing a $30 million mixed-use development project in a growing downtown core.

The developer’s looking to balance financing sources with risk allocation to attract investors and reduce overall exposure.

Model Capital Stack Breakdown

• Senior Debt – $18 million (60%)
  Sourced from a national bank, this piece carries the least risk and earns interest first.
• Mezzanine Debt – $3 million (10%)
  Structured as a loan with equity-like features, often from a private lender or hedge fund.
• Preferred Equity – $4.5 million (15%)
  From a family office or institutional equity group, offering fixed preferred returns.
• Common Equity – $4.5 million (15%)
  Funded by the developer and outside partners. This layer has the highest upside, but also the most risk.

How Different Economic Scenarios Impact Each Layer

In a strong market, the project performs well and everyone gets paid, plus common equity holders see upside.

In a flat market, returns may cover only senior debt and mezzanine. Preferred might take a haircut, and common equity may get nothing.

In a downturn, only senior debt might see repayment, leaving the rest exposed.

Key Lessons For Investors

• Understand your repayment priority before jumping into a deal.
• Structure your entry point based on your risk tolerance.
• Ask what happens if rents stall, costs go up, or lease-up takes longer.

In short, savvy investors use capital stack organization to protect downside while aiming for upside. Making that decision early, before the deal closes, can be the difference between steady returns and sleepless nights.

Beyond the Blueprint: Your Funding Options Within the Capital Stack

While understanding the overall capital stack is important, let’s briefly go on a tangent and focus to the individual investor.

You might be thinking, “This is all fascinating, but how do I, as an individual, even get a seat at this table? Where does my money come from to participate in these different layers?” That’s an excellent question!

Securing your individual funding is a crucial first step, regardless of whether you’re aiming for the relative security of preferred equity or the higher-risk, higher-reward potential of common equity. Many investors tap into a variety of sources, including personal savings & investments, tax-advantaged accounts, strategic partnerships, and debt leveraging.

By exploring your individual funding options, you can increase your chances of finding the right fit for your goals, risk tolerance, and available resources.

Ultimately, successful real estate investing involves both a macro view (understanding the overall capital structure) and a micro view (managing your individual funding strategies).

Final Thoughts

Don’t think understanding the capital stack is for Wall Street pros. It’s a practical tool for anyone looking to invest smarter in commercial real estate. Knowing where your money sits in the stack helps you gauge risk, forecast returns, and make decisions with more confidence.

Take time to evaluate how each layer fits with your goals and risk tolerance before jumping into a deal. If you’re diving deeper into real estate or just want clearer, no-fluff breakdowns like this one, check out our homepage and explore more insights designed to help you grow.