Real estate capital stack explained: Structure, risk & returns

Most commercial properties are financed from multiple sources that make up a “capital stack.” To optimize your investment’s capital stack, you must first understand how it works. 

What is the real estate capital stack?

The real estate capital stack is the hierarchy of financing sources used to fund a project. There are four main layers: common equity, preferred equity, mezzanine debt, and senior debt. 

Each layer comes with a different trade-off between risk and potential return. For example, common equity provides the most upside but also the most risk, while senior debt provides the least upside but also the least risk.

Why the capital stack matters for real estate investors

As a real estate investor, understanding a deal’s capital stack helps you:

• Determine where risk truly sits
• See how cash flows move through a deal
• Ensure alignment between sponsors and investors
• Support due diligence and deal comparisons
• Set realistic return expectations

How capital layers are structured in a real estate deal

Let’s dive deeper into each layer of the capital stack:

Common equity	Common equity is held by the sponsor(s) and investors. It earns returns only after all other parties in the capital stack have been paid. However, it also has the most upside since it’s entitled to any excess returns.
Preferred equity	Preferred equity has priority over common equity and is entitled to a set minimum return after the deal’s debt obligations are satisfied.
Mezzanine debt	Mezzanine debt is a hybrid between equity and debt financing. It charges higher interest rates than senior debt because it is paid second. However, mezzanine lenders may have the right to foreclose on ownership interests or convert to equity in a default.
Senior debt	Senior debt is a mortgage. It earns the lowest return rate (in the form of interest) but is also paid out first. Plus, the financing is secured by a first lien on the property.

Generally, day-to-day operational control lies with common equity holders. However, preferred equity and debt holders maintain significant protective rights and approval authority over major decisions, effectively trading control for more secure returns and priority in the capital stack.

How capital layers function in practice

Now that you know what each layer of the capital stack is, let’s explore how they are used:

When and why sponsors use senior debt

Securing senior debt can lower the upfront cost of a real estate investment, provide low-cost capital, and even result in higher potential returns. This is the case when the interest on the debt is lower than the return on the investment (aka positive leverage). 

How mezzanine financing and preferred equity bridge funding gaps

When you’ve exhausted your bank loan options but still lack funding (or simply want to diversify funding), mezzanine and preferred equity financing may do the job. Mezzanine is often offered by real estate funds, life insurance companies, or individuals, while preferred equity is offered by investors willing to accept capped returns with less risk.

Role of common equity in deal ownership

The sponsor(s) and limited partners (LPs) put up common equity. Consider this the down payment on the deal. In exchange for taking on the most risk, common equity holders also have the most control over how the deal is managed. 

Pros and cons of each capital layer

Of course, each capital layer comes with unique advantages and disadvantages.

Senior debt

• Pros: lowest-cost capital, widely available, potential to boost returns through leverage
• Cons: mandatory payments regardless of deal performance, stricter requirements

Mezzanine debt

• Pros: added leverage without exhausting senior debt, doesn’t require giving up equity
• Cons: higher interest rates, adds another debt payment, can lead to overleveraging

Preferred equity

• Pros: fills funding gaps without taking on more debt, doesn’t trigger debt covenants
• Cons: gives up equity, must be paid before the sponsor is paid

Common equity

• Pros: no debt payments, aligns sponsor and investor interests
• Cons: most expensive form of capital, requires the hardest fundraising, gives up equity

How risk and return change across the capital stack

For investors, each capital layer has a different risk-return profile. As you rise from senior debt to common equity, the risk and potential reward increase (and vice versa).

Differences in downside protection and recourse

Part of what lowers debt investors’ risk is built-in downside protection. For example, senior debt is secured by the property, meaning the lender can seize it if the sponsor defaults on the loan. For recourse loans, the lender can even go after the sponsor’s personal assets.

Meanwhile, common and preferred equity investors have little to no recourse, and any losses are considered part of the risk they take on in exchange for unlimited upside. 

Typical return ranges across capital layers

While returns can vary widely by market and deal, here are common return ranges:

• Senior debt: 4-7%
• Mezzanine debt: 8-10%
• Preferred equity: 10-15%
• Common equity: 15-30%

How the capital stack affects distribution and waterfalls

The capital stack determines how real estate investment proceeds are distributed. This includes the sequence of payouts across capital layers (senior debt, then mezzanine debt, then preferred equity, then common equity) and how returns are split among investors within each layer.

Preferred returns vs. promote structures

Within the common equity layer, distributions are often structured as waterfalls with multiple tiers. Think of them as buckets. Once the first bucket is full, proceeds spill into the next bucket.

Typically, proceeds move through tiers based on return hurdles. Here’s an example:

• Tier 1: All distributions go to limited partners (LPs) until they receive an 8% preferred return (their hurdle rate).
• Tier 2: After the 8% preferred return is met, remaining proceeds are split 80/20 between LPs and the sponsor.
• Tier 3: After LPs achieve a 15% IRR, the split shifts to 70/30 in favor of the sponsor.

The sponsor’s disproportionate share after higher hurdles is called promoted interest or promote. It incentivizes the sponsor to maximize returns above the preferred return threshold.

Keep in mind that this waterfall structure is separate from the capital stack itself. Debt and preferred equity receive their contractual payments first, then the common equity waterfall determines how the remaining proceeds are split between LPs and the sponsor.

Impact on LP expectations and reporting

Different capital positions may warrant different levels of reporting. As a sponsor, establish clear reporting standards with investors upfront and communicate proactively, especially when performance falls behind projections. Waiting too long can erode trust, while early communication helps maintain strong investor relationships even during difficult periods.

Common mistakes when evaluating a capital stack

When evaluating a capital stack, avoid these common pitfalls:

Misreading priority and repayment order	Misunderstanding the payment sequence can lead you to over-promise returns to investors or misjudge your own capital position.
Missing key investor protections	Carefully review loan covenants and restrictions that could limit your ability to manage your investment the way you want.
Skipping scenario or sensitivity analysis	Failing to model delays, cost overruns, or market downturns could leave you blindsided when the deal doesn’t perform as expected.
Overlooking investor motivations and fee structures	Misaligned fee structures and incentives can create unnecessary friction between you and other stakeholders.
Misjudging where losses occur in downside scenarios	Underestimating how quickly losses can wipe out equity positions may lead you to take on too much risk.
Ignoring debt terms and opportunity costs	Don’t take on too much leverage and compare risk-adjusted returns to other investment opportunities before committing.

Capital stack considerations for different real estate strategies

Your real estate investment strategy can also impact how you structure your capital stack.

Ground-up development capital needs

Ground-up development typically requires the most equity because it involves the most risk: construction risk, lease-up risk, market timing risk, etc. 

Value-add capital stack structures

Value-add deals typically use moderate leverage. They’re more risky than stabilized assets but less risky than ground-up developments. 

Stabilized/core asset financing

Stabilized assets can support the highest leverage because they have a proven track record and fewer things that can go wrong. In short, lenders are more comfortable financing them.

Note: You may also need to adjust the syndication structure based on market conditions. For instance, a volatile market may call for less leverage to protect your downside. 

Conclusion

As a sponsor or fund manager, mastering the capital stack can help you attract investors and maximize returns. The key is balancing leverage to enhance returns without overleveraging, aligning investor interests through well-designed waterfall distributions, and clearly communicating the risk-return profile of each capital layer. This not only makes your deals more competitive but also helps you build long-term trust and credibility.