Structuring a Commercial Real Estate Capital Stack

Every layer in a capital stack carries a different claim on the property and a different price for taking that risk. Senior debt gets paid first and charges the least because a first mortgage lien gives it the strongest protection. Equity gets paid last, after every debt layer is satisfied, and demands the highest return because it absorbs losses first if the deal underperforms. Structuring a stack correctly starts with understanding that this ordering is not a formality.

A sponsor building a stack for the first time often thinks about it purely as filling a dollar gap between total cost and available cash. That framing misses a more useful question: what is the cheapest combination of capital that still lets each provider underwrite comfortably. A senior lender that feels overextended will price up or decline. A mezzanine lender stacked behind a senior loan with weak covenants will demand more protection in return.

Senior debt is typically a first mortgage bridge or construction loan, interest-only, sized against the as-is or as-completed value of the property and the business plan behind it. Mezzanine debt sits immediately above it, secured by a pledge of the ownership interests in the borrowing entity rather than a lien on the real estate itself, and is repaid current or with a portion accruing to preserve senior debt service coverage. Preferred equity occupies a similar economic position but is structured as an equity investment with a preferred return and defined exit mechanics rather than a loan.

Common equity and GP equity sit at the top of the stack and take the residual risk and residual upside. Common equity is typically the limited partner capital raised from investors, while GP equity is the sponsor's own contribution, often required by senior and subordinate providers alike as evidence the sponsor has meaningful capital at risk alongside everyone else in the deal.

Senior debt sizing usually starts from two tests run at once: loan to value or loan to cost against the property, and debt service coverage against projected income. Whichever test produces the lower number typically sets the ceiling on the senior loan amount. A sponsor should run both tests early, since a deal that looks well leveraged on a loan to cost basis can still fall short on a debt service coverage basis if in place income is thin.

Mezzanine debt and preferred equity are then sized against the remaining gap between the senior loan and total project cost, net of the equity the sponsor plans to raise. Providers of this layer look closely at combined leverage across both the senior loan and their own piece, since their recovery depends on the value cushion above the senior debt, not against the property's full value alone.

Each layer carries a different rate, and the blended cost of the whole stack is what determines whether the deal's projected return clears the sponsor's target. A stack with a large senior loan at a lower rate and a thin slice of more expensive mezzanine debt or preferred equity above it will blend to a lower overall cost than a stack that leans heavily on subordinate capital to reach the same total leverage.

As an illustration, consider a $20,000,000 acquisition. A senior bridge loan of $13,000,000 at an illustrative 9% rate, paired with $3,000,000 of mezzanine debt at an illustrative 12% rate and $4,000,000 of sponsor and investor equity, blends to a weighted debt cost well below what the same deal would carry if the mezzanine piece were $6,000,000 instead of $3,000,000. Running this blend before approaching any single provider tells a sponsor how much subordinate capital the deal can actually absorb.

A senior lender and a mezzanine lender or preferred equity provider typically sign an intercreditor or subordination agreement that spells out standstill periods, cure rights, and what happens if the borrower defaults on either obligation. Senior lenders commonly limit how much additional debt can sit behind them and reserve approval rights over any subordinate financing before it closes, which means the subordinate layer has to be identified and negotiated early, not added after the senior loan documents are final.

The operating agreement among the equity holders does similar work at the top of the stack, setting out capital call obligations, distribution waterfalls, major decision rights, and what happens if a partner fails to fund. A capital stack that looks clean on a sources and uses table can still stall in documentation if the intercreditor agreement and operating agreement were not drafted with each other in mind from the start.

Most sponsors approach the senior lender first, since its terms constrain what subordinate capital can and cannot do. Once the senior loan is sized and its major covenants are known, a sponsor can approach mezzanine or preferred equity providers with a clear picture of the collateral position and cash flow available to service their layer, which shortens the underwriting conversation considerably.

Equity is often raised in parallel with the subordinate debt search, since investors want to see the debt stack finalized before committing, and debt providers often want to see committed equity before finalizing terms of their own. Sponsors who manage this sequencing well typically get soft commitments from both sides before either is asked to sign.

The most frequent mistake is sizing the stack around the sponsor's target return rather than what each provider will actually underwrite, which produces a plan that looks good on a model but cannot be placed with real capital. A close second is approaching subordinate lenders before the senior loan terms are known, which forces a second round of negotiation once the senior lender's covenants turn out to limit what the subordinate layer can do.

H Equities evaluates and structures capital across multiple layers of the stack, including first mortgage bridge loans from $5,000,000 to $50,000,000, mezzanine loans from $3,000,000 to $15,000,000 secured by a pledge of ownership interests, preferred equity from $3,000,000 to $15,000,000, and co-GP equity from $1,000,000 to $4,000,000, which allows a sponsor to have more than one layer of a stack evaluated by a single team. Elliot Horowitz, Managing Member of H Equities, has worked as a broker, equity partner, bridge lender, and asset manager.