Why the capital stack is vital in commercial real estate

At the foundation of the capital stack sits senior debt, which is considered the lowest risk of financing and real estate investing. It takes precedence and repayment priority over other forms of capital and layers in the capital stack in the event of default. For this reason, it typically offers the lowest interest rates. Historically, senior debt was primarily provided by major banks or institutional lenders. However, in the last decade, there has been a notable trend: an increasing number of real estate developers are turning to non-bank and private lenders for senior debt funding. This shift is driven by the desire for faster processing, greater transparency, and enhanced flexibility in financing arrangements.

Mezzanine debt occupies a unique position within the capital stack, positioned between senior debt and equity financing. Unlike senior debt, which holds a priority position in repayment – the highest, mezzanine debt ranks lower in repayment priority. This means that in the event of default or liquidation, senior debt holders are entitled to be repaid before mezzanine debt holders receive any proceeds. Due to this increased risk, mezzanine debt typically attracts a higher interest rate compared to senior debt. Lenders and private credit investors providing mezzanine financing accept a greater level of risk, as their investment stands to be repaid only after senior debt obligations have been met. Therefore, to compensate for this heightened risk, mezzanine debt attracts higher interest rates, reflecting the increased potential for loss in the event of default. Despite its higher cost, mezzanine debt remains an attractive option for real estate developers seeking additional capital beyond what senior debt can provide when financing real estate projects.

Preferred equity represents a distinct layer within the capital stack, offering investors a hybrid form of financing that combines elements of both debt and equity. Preferred equity investors hold a position senior to common equity but subordinate to – or after – debt. Unlike common equity, preferred equity holders typically receive fixed dividends or priority distributions from the project’s cash flows. This preferential treatment entitles them to receive returns before common equity holders but after senior debt obligations have been met. However, preferred equity investors generally do not have full participation in the project’s upside potential. Despite this, preferred equity presents a lower risk compared to common equity, as investors’ returns are more predictable and stable. Nevertheless, this stability comes at the cost of potentially lower overall returns compared to common equity. Investors in preferred equity must weigh the trade-off between lower risk and potentially lower returns, making it essential to carefully evaluate the risk-return profile of preferred equity investments within the broader context of the capital stack.

Common equity represents the ownership stake in the project. Equity investors bear the highest risk but also stand to gain the highest returns if the project succeeds. They have voting rights and share in the project’s profits, but their returns are not guaranteed and are subject to the real estate development project’s performance.