The Capital Stack: Senior Debt, Mezzanine, Preferred Equity, Common Equity
A syndication is a securities offering sitting on top of an ordinary piece of commercial property finance. The stack is the second half, and it decides whether the first half ever sees a dollar.
Before there is a syndication there is a building, and before there is a building there is a way of paying for it. The capital stack is that second thing: the complete set of claims on a property, arranged by who gets paid first and who absorbs loss first.
It is worth learning as a shape rather than as a list of definitions, because once the shape is clear the rest of private real estate follows from it almost mechanically. Two rules govern the whole arrangement:
- Cash flows from the bottom up. The property's income pays the most senior claim first, and only what remains moves upward.
- Losses are absorbed from the top down. The most junior claim is written to zero before the layer beneath it takes a dollar of damage.
Every argument about risk and return in a syndication is a restatement of those two sentences.
A hypothetical capital stack on a $10,000,000 acquisition
- Common equity — GP$300,0003%
- Common equity — LPs$2,200,00022%
- Preferred equity$1,000,00010%
- Senior mortgage debt$6,500,00065%
Read that figure from the bottom. The senior lender advanced most of the money and takes the least risk. The limited partners advanced about a fifth and stand behind everyone. The sponsor's own contribution is at the very top, in the same position as the limited partners or sometimes junior to them.
Senior debt: the floor everything else stands on¶
The first mortgage is secured by a lien on the real estate itself. It is the largest single component of most stacks, the cheapest capital in the deal, and the layer whose terms shape the risk of everything above it.
Four of its terms matter more than the interest rate:
Fixed or floating. A fixed-rate loan converts interest into a known quantity for its term. A floating-rate loan prices over an index, which means the deal's largest expense is unknown for the duration. Floating debt is generally paired with an interest rate cap, which expires — usually well before the loan does.
Term and maturity. A loan matures whether or not the business plan worked. What happens at maturity is the single most common point of failure in a syndication, because the property has to be refinanced or sold on whatever terms exist that month.
Amortization. Interest-only periods raise distributable cash early and leave the balance undiminished at maturity. Amortizing debt does the reverse.
Covenants and recourse. Coverage ratio tests, reserve requirements and cash management triggers give the lender the ability to intervene before a default. Most syndication debt is non-recourse to the investors, with carve-outs — the "bad boy" guaranties — that a sponsor principal signs personally.
Mezzanine debt: a loan against the owner, not the building¶
Mezzanine debt sits above the senior loan. What distinguishes it is its collateral: it is secured not by the real estate but by the ownership interests in the entity that owns the real estate.
That distinction has a practical consequence that matters to anyone holding equity above it. Foreclosing on a mortgage is a slow judicial or statutory process measured in months. Enforcing a pledge of ownership interests is governed by Article 9 of the Uniform Commercial Code and can be accomplished in weeks. A mezzanine lender exercising its remedy does not take the building; it takes the company that owns the building, and everyone above it in the stack goes with it.
The relationship between the senior and mezzanine lenders is governed by an intercreditor agreement, which sets out who may act, when, and on what notice. Equity holders are not parties to that agreement, but its standstill periods and cure rights determine how much time a struggling business plan actually has.
Preferred equity: an equity position with a debt's temperament¶
Preferred equity occupies similar territory to mezzanine debt and is legally quite different. It is an equity interest in the owning entity, entitled to a stated return before the common equity receives anything.
Because it is equity rather than debt, it usually does not trigger the senior lender's prohibition on additional indebtedness, which is much of why it exists. Its terms typically include:
- A fixed preferred rate, often with a portion paid currently and a portion accruing.
- A redemption date by which the position must be repaid.
- Remedies on failure, which can include the right to force a sale of the property or to remove the common equity's control over the entity.
That last one is the reason preferred equity introduced late into a struggling deal is a serious event for existing limited partners rather than a rescue. A preferred position with a high accruing return, sitting ahead of the common equity and compounding, can consume the entire realistic proceeds of a sale.
Common equity: the top of the stack, which is where you are¶
Common equity is the residual. It receives what remains after debt service and every preferred claim, and it is written down to zero before any of them take a loss.
In exchange it holds the entire upside. Once the fixed claims are satisfied, everything above them belongs to the common equity — which is exactly why leverage raises returns when a deal works. A property that appreciates ten percent produces a much larger percentage gain for equity that funded a fifth of the purchase price. The same arithmetic runs in reverse, and faster.
Limited partner interests in a typical syndication are common equity, sometimes divided into classes with different priorities. Where an offering has Class A and Class B units, the two classes are both common equity relative to the debt, and one has a priority relative to the other.
Loan-to-value, loan-to-cost, and why neither is the answer¶
Three ratios describe the same stack and they are not interchangeable.
Loan to value measures the senior loan against an appraised value. The weakness is that value is an opinion produced at a moment, by an appraiser engaged in connection with the transaction, using assumptions about income and capitalization rates.
Loan to cost measures the loan against what is actually being spent — purchase price plus the capital budget plus costs. It is harder to influence, because cost is a fact rather than a valuation.
Debt yield measures net operating income against the loan amount, ignoring both value and interest rates. Lenders increasingly rely on it precisely because it cannot be improved by a favorable appraisal or a low rate.
| Ratio | Numerator and denominator | What it can be flattered by |
|---|---|---|
| Loan to value | Loan against appraised value | An optimistic appraisal or capitalization rate |
| Loan to cost | Loan against total spend | Little; cost is observable |
| Debt yield | Income against loan | Little; both figures are observable |
None of the three answers the question that matters, which is whether the property's income covers its debt service under conditions worse than projected. That is the coverage ratio, and it is the one a lender tests every quarter.
Reading a stack you have been shown¶
The sources and uses table in an offering shows the stack as of closing. Three things are worth extracting from it.
| What to work out | Why it matters | Where it comes from |
|---|---|---|
| Total debt as a share of total capitalization | Sets how much cushion exists above the lenders | Sources side, all debt layers added together |
| Whether any layer above the senior loan exists | Preferred and mezzanine change the order of losses entirely | Sources side; look for anything that is not the mortgage or the equity raise |
| What proportion of the raise buys the property | Fees and reserves are funded out of the same equity you contribute | Uses side, purchase price against the total |
| Interest-only period against loan term | Distributions early can be a function of amortization structure rather than performance | Debt terms in the memorandum |
The stack determines the floor of the analysis, not the ceiling. A conservative stack on a bad property still loses money, and an aggressive stack on a well-bought asset in a stable market can be entirely reasonable. What the stack tells you is how much has to go right before anything reaches you, and how little has to go wrong before nothing does.
Once the stack is understood, the next question is what happens to the cash that does reach the equity, which is the subject of the distribution waterfall.
Primary sources
Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.
- SEC, private placements under Rule 506(b)sec.gov
- Federal Reserve, Financial Stability Report and commercial real estate exposuresfederalreserve.gov
- FDIC, Supervisory guidance on commercial real estate concentrationsfdic.gov
- Freddie Mac, Multifamily loan products and mezzanine financingmf.freddiemac.com
Questions readers ask
What is the capital stack in simple terms?
It is the full set of claims on a property, arranged by priority. Senior mortgage debt sits at the bottom with the first claim on cash and on the asset, junior layers sit above it, and common equity sits at the top. Money flows from the bottom up, losses are absorbed from the top down.
Where does a limited partner sit in the capital stack?
Almost always at the very top, in common equity. That position receives whatever is left after every other layer has been satisfied, and it is written down to zero before any layer below it takes a loss at all.
Is preferred equity the same as mezzanine debt?
No, though they occupy similar territory. Mezzanine debt is a loan secured by the ownership interests in the property owner; preferred equity is an equity position with a priority return. They behave differently on default, and the remedies available to their holders are different.
What loan-to-value ratio is safe?
There is no safe ratio, because the number that matters is whether the property's income covers the debt service under stress, not what percentage of a valuation the loan represents. A valuation is an opinion at a moment; a debt service payment is a fact every month.
Does more leverage always mean more risk for the equity?
It magnifies both directions. More leverage raises the return on equity when the property performs and destroys the equity faster when it does not, because the debt has to be paid before anything reaches the top of the stack whatever happens.
Read next
- StructuresHow a Real Estate Syndication Is Actually StructuredA syndication is two things stacked on each other: a piece of commercial property finance, and a securities offering sold under an exemption from registration.
- StructuresLLC vs Limited Partnership: Which Entity Holds the PropertyBoth give passive investors limited liability and pass-through taxation. The differences are the sponsor's exposure and which document to ask for.
- StructuresRegulation D 506(b) vs 506(c): What Changes for the InvestorOne exemption forbids advertising and takes your word on accreditation. The other permits public marketing and requires documentary proof.