The Real Estate Capital Stack: Senior Debt, Mezz, Preferred Equity and Common

The capital stack is the set of layers of financing used to buy or build a property, ranked by who gets paid first and who takes losses first. From the top: senior debt, mezzanine debt, preferred equity and common equity. Higher layers are paid first and carry less risk, so they usually earn less. Lower layers earn more when things go well and lose first when they do not.

If you are the sponsor, we built DoorRaise to raise the equity layer for 5+ unit apartment deals. For the wider picture, see our pillar guide to real estate syndication.

What are the layers of the capital stack?

There are four layers, and the order is the point. Each layer is paid before the one below it and absorbs losses after the one above it.

Senior debt

Senior debt is the main loan, secured by a mortgage on the property. The lender has the first claim on the property and its income. If the borrower defaults, the lender can generally foreclose, following the loan documents and state law.

Mezzanine debt

Mezzanine debt is a smaller, subordinate loan. It is usually secured by the ownership interests in the company that owns the property, not by the property itself. Mezzanine lenders often have rights to take control of the company if the loan is not paid, and the senior lender commonly requires an agreement between the two lenders, called an intercreditor agreement.

Preferred equity

Preferred equity is an investment in the owning company that ranks ahead of common equity, typically with a stated return. It is not a loan, so it does not carry a mortgage, but its documents may give the investor rights if payments are missed. Terms vary by deal.

Common equity

Common equity is whatever remains after everyone above is paid. It is where the sponsor's promote and most investor capital live, and it takes the first loss.

Where do syndication investors sit in the stack?

Syndication investors usually sit in common equity or in an investor class within the equity, below all debt. A preferred return gives them priority over the sponsor's promote, but it does not put them ahead of the lender.

Because Rule 506 offerings are private placements, the interests are also restricted. Under Rule 502(d), buyers must be told the securities are unregistered and restricted. So investors are at the bottom of the stack and cannot easily sell. Those two facts together explain much of the risk in a syndication.

An illustrative example: what happens to each layer at sale

The numbers below are illustrative and simplified. They are not a projection. A sponsor buys a building and funds total costs of $10,500,000 with four layers.

Now the building is sold, with 2% selling costs, at three prices. To keep it simple, the example ignores interest paid along the way, accrued preferred returns, any sponsor promote and interim cash flow. It pays senior debt first, then mezzanine, then preferred equity, and gives the remainder to common equity.

Senior, mezzanine and preferred layers are paid in full in all three cases. The common layer swings between a 67% loss and a 50% gain on a sale price that moves 14.3% in each direction from total cost. Even selling at exactly the total cost loses 8.4%, because of selling costs. This is what leverage does: it concentrates the result in the bottom layer.

The common equity is gone entirely once the sale price falls to about $8.16 million, because the layers above it total $8,000,000 and 2% selling costs come out first. The more layers above you, the less room for error.

How does leverage change risk for equity?

Leverage raises both the possible return and the chance of losing equity, because loan payments are fixed while income is not. A property with a thin cushion over its loan payments can quickly stop producing distributions.

Measures that matter

• Loan-to-value (LTV) and loan-to-cost (LTC). LTV is the loan divided by the property's value, and LTC divides by cost. In the example, the senior loan is about 61.9% of cost, and total debt is about 71.4% of cost, which is $7,500,000 of $10,500,000.
• Debt service coverage ratio (DSCR). NOI divided by annual debt service. See multifamily underwriting basics for the math and a stress test.
• Rate type and term. Fixed or floating, interest-only or amortizing, and when it matures.
• Recourse. Whether the sponsor is personally liable, and for what.

Debt also matters for investor taxes

For tax purposes, debt can affect how much loss a partner can deduct. The IRS K-1 instructions describe basis, at-risk and passive activity limits, and note that nonrecourse loans are generally not at-risk, though a special rule for qualified nonrecourse financing secured by real property (26 U.S.C. 465(b)(6)) can change that. Your CPA should review how the deal's debt affects you. See K-1s in real estate syndication.

Why do sponsors add mezzanine or preferred equity?

Sponsors add extra layers to reduce the cash equity they need to raise, to fund renovations, or to fit a deal into what the senior lender allows. The layers can make a deal possible, but they add cost and a claim ahead of common equity.

Questions about extra layers:

1. How much does the extra layer cost per year, and is the return paid in cash or accrued?
2. What rights does the holder get if payments are missed, such as taking control?
3. Is the layer repaid before the investors in a sale or refinance?
4. Does the extra layer have its own maturity date, and does it come due before the senior loan?

Private real estate structures differ from public ones, but the same questions apply. The Investor.gov bulletin on REITs lists leverage and conflicts with outside managers among risks for real estate investments, which is a useful checklist even for non-REIT deals.

What should you ask about a deal's capital stack?

Ask for the stack in writing and ask who is above you. The sources and uses table in the offering documents should show every layer.

1. What are all the layers, and how much is each?
2. Who holds the mezzanine or preferred layer, and what are their remedies?
3. Is the senior loan fixed or floating, and when does it mature?
4. What happens to my distributions if debt service is not covered?
5. Does the sponsor guarantee any of the debt, and is the guarantee limited?
6. Is there a reserve, and how large is it?
7. Can the sponsor raise more capital later, and how would it rank against me? See what is a capital call.

Our checklist for vetting a syndication turns these into diligence steps.

Our take

Our take: the capital stack is the first page of a deal worth reading, because it shows how much has to go right. We would rather see a sponsor choose fewer layers, even if it means a smaller deal, than stack mezzanine and preferred equity until the common equity is a thin slice on top.

We also think sponsors should explain every layer in plain English in the offering materials, including what happens to investors if the plan falls short. If a layer is hard to explain, that is a reason to look at it harder.

Trade-offs and who this is not for

Understanding the stack improves your questions, but it does not tell you whether a deal is good. Complex stacks are also not always bad.

• More debt is not automatically worse. Moderate leverage with fixed-rate debt and a strong cushion can be reasonable. The risk is leverage the property cannot carry.
• Preferred equity is not always safer. It ranks ahead of common but behind debt, and its protections depend on the documents.
• Complex stacks need legal review. Intercreditor terms and control rights can change who wins in a downturn.
• Not for investors who want a guaranteed outcome. No layer is guaranteed except by its documents, and even senior lenders can lose money in a severe downturn.
• Not for investors who need to exit quickly. Private equity layers are illiquid.

How DoorRaise fits in

DoorRaise is for the equity side: software, legal document preparation, escrow coordination and verification services for sponsors raising equity for 5+ unit apartment buildings under Rule 506(b) or 506(c). The debt is arranged separately between the sponsor and the lender, and DoorRaise does not recommend, rank or endorse any offering. We take 0% of the raise or profits.

The deal's legal company, the LLC, is formed in the $500 setup fee, along with investor documents from attorney-approved templates, an escrow account in the deal's name, the deal page and accreditation checks on every investor. The $5,000 closing fee is paid from funds raised and only if the deal closes, and it includes checks of the purchase contract, title and lender term sheet. The $3,500 yearly fee covers bookkeeping, the tax return and K-1s for every investor. State filing fees are included in the $5,000 closing fee. Funds go to an independent escrow agent, and DoorRaise does not hold investor money. See pricing.

Ready to raise? Create your free sponsor page or see pricing.

FAQ

Is preferred equity the same as a preferred return?

No. Preferred equity is a class of equity that ranks ahead of common equity. A preferred return is a payout priority within the equity, often paid to investors before the sponsor's promote. A deal can have either, both or neither.

Is mezzanine debt the same as a second mortgage?

Not exactly. A second mortgage is secured by the property. Mezzanine debt is usually secured by the ownership interests in the company that owns the property. The remedies are different.

Does more debt mean a better deal?

Not by itself. More debt can raise returns in good conditions and raises the chance of losing equity in bad ones.

Where do I find the capital stack for a deal?

In the offering documents, usually in a sources and uses section or a summary of the financing. If you cannot find it, ask the sponsor to provide it in writing.

Where do I sit in a syndication's capital stack?

Usually in common equity or an investor class of equity, below all debt. Your exact position is set by the operating agreement, so read it with your attorney.

Can the equity lose money even if the lender is repaid?

Yes. The lender is repaid first. In the example above, the senior, mezzanine and preferred layers were paid in full at a $9,000,000 sale, while common equity lost about 67%.

Sources

• 17 CFR 230.506, Exemption for limited offers and sales
• 17 CFR 230.502, General conditions to be met
• IRS, Partner's Instructions for Schedule K-1 (Form 1065)
• Investor.gov, Investor Bulletin: Publicly Traded REITs
• The ordering of senior debt, mezzanine debt, preferred equity and common equity is standard industry usage, not a legal definition.

The example is simplified and illustrative, not a projection. This article is general information, not legal, tax or investment advice. Talk to a securities attorney and a CPA about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.