Capital Stack 101: How Commercial Real Estate Deals Are Actually Financed
Every commercial deal stacks different types of capital — senior debt, mezzanine, preferred equity, sponsor equity — each with different pricing, risk, and default priority. Here's the primer.
Key Takeaways
- Capital stack = the arrangement of different capital types funding a deal, ordered by priority in default. Senior first, then mezz, then pref equity, then common equity.
- Typical CRE stack: 60-75% senior debt (6-9%), 15-20% mezzanine (11-15%), 5-10% preferred equity (11-18% total return), 10-25% sponsor common equity (target 15-25% IRR).
- Each layer prices to its risk position. Higher in the stack = more risk = higher return required. Senior lenders accept lower yield for priority position; equity holders demand higher yield for last position.
- Capital stack design determines sponsor equity commitment, cash flow during hold, IRR at exit, and downside protection. Most important decision made BEFORE signing LOI.
- Agency debt (Fannie DUS, Freddie Optigo) on multifamily prohibits most mezzanine — preferred equity fills the gap. Different senior lenders have different intercreditor preferences.
The Basic Stack
Imagine funding a $10M commercial property purchase. You don't write a $10M check. You layer different capital types:
**Senior debt** — the first mortgage on the property, typically 60-75% of total capitalization. Lowest priced (6-9% in April 2026) because it's paid first in any default scenario. Sources: CMBS conduits, banks, life insurance companies, agency multifamily lenders.
**Mezzanine debt** — subordinated financing secured by a UCC pledge of the equity in the property-owning LLC (not a second mortgage). Typically 15-20% of total cap. Priced 11-15% current-pay because paid second in default. Sources: institutional mezz funds, middle-market mezz specialists.
**Preferred equity** — equity with priority distribution rights. Fills gaps above 85% LTC when mezz isn't available (e.g., agency senior prohibits mezz but allows pref). Priced 11-18% total return. No foreclosure rights — contractual remedies only.
**Sponsor common equity** — the last-in-line capital. Paid last in default. Target IRR 15-25%+ to compensate for bearing maximum risk.
On the $10M deal: $6.5M senior at 7.5% + $1.5M mezz at 12% + $2M sponsor equity = $10M total. Simple stack, common structure.
Why Each Layer Exists
Each layer serves a specific purpose in optimizing the deal:
**Senior debt maximizes leverage at lowest cost.** Senior lenders are comfortable with 60-75% LTV because they have first claim on the real estate in default. Senior is cheap capital — use as much as the property cash flow supports at the required DSCR.
**Mezzanine lifts the stack above senior's limit.** Senior caps at 65-75% LTV. If the sponsor wants 80-85% combined leverage to amplify equity returns, mezzanine fills the gap from 65% to 80%. Mezz pays debt-style current interest + often has a PIK (accruing) portion. Tax-deductible to borrower.
**Preferred equity serves when mezz doesn't fit.** Agency senior debt prohibits mezz. Deals needing 85%+ combined leverage go above mezz cap. Pref equity is equity but with priority — pays distributions before common equity, accrues preferred return if cash flow insufficient.
**Sponsor common equity is the first-loss position.** It bears all downside risk but captures all upside above preferred returns. Sponsor equity targets high IRR (15-25%+) to compensate for risk. The equity thesis — why the sponsor believes the deal returns above the cost of preferred capital — drives everything.
How Each Layer Prices
Pricing reflects risk position. Priority (senior) gets paid first; risk declines. Subordination (common equity) gets paid last; risk rises.
**Senior debt pricing factors:** Property type (multifamily tightest at 6-7.25%, industrial 6-7.5%, retail 6.5-8.5%, hotel 6.5-9%, office 7.5-10%), LTV (lower LTV prices tighter), DSCR (higher DSCR prices tighter), sponsor credit (institutional sponsor tightest), market (primary market tighter than secondary), loan term (longer term + higher rate).
**Mezzanine pricing factors:** Subordination level (65-80% LTC mezz tighter than 80-85%), asset class (multifamily/industrial tighter than hotel/office), sponsor profile (institutional tighter than middle-market), deal size (larger tighter). Typical 11-15% current + 1-3% PIK.
**Preferred equity pricing factors:** Senior lender prohibitions on mezz force pref equity, which prices 100-200 bps wider than mezz for equivalent subordination due to lack of foreclosure remedy. Total return 11-18% (current + accrued).
**Common equity pricing:** Target IRR 15-25%+ depending on risk profile. Core stabilized 12-15%. Value-add 18-22%. Development 22-30%. Sponsor commits equity in exchange for GP promote above preferred return hurdles.
The Default Waterfall
In default, payment priority flows in order:
1. **Senior debt** — first claim on property cash flow and liquidation proceeds. Gets paid until principal + accrued interest recovered.
2. **Mezzanine debt** — second claim via UCC foreclosure on LLC equity. In a mezz foreclosure, mezz lender takes control of the LLC (which owns the property), typically in 30-60 days. Bypasses slow judicial real estate foreclosure.
3. **Preferred equity** — paid after all debt, before common equity. No foreclosure rights; remedies are contractual (force sale, GP removal, accrue penalty return). Slow to enforce (6-18+ months).
4. **Common equity** — paid last. In distressed scenarios, often recovers nothing. Bears the first-loss risk in exchange for the upside above preferred returns.
**Intercreditor agreements** formalize relationships between senior and mezz lenders: senior has cure rights on mezz default (prevents mezz foreclosure if senior wants to keep deal current), mezz has cure rights on senior default, standstill periods during workouts, priority of proceeds distribution.
Understanding the waterfall matters because deal returns compound based on who gets paid what, when. Sponsor common equity in a struggling deal may get nothing; same sponsor in a successful deal captures multiples of original equity.
Designing the Right Stack for Your Deal
Capital stack design depends on: (1) property type + stabilization status, (2) sponsor profile + experience + equity available, (3) hold horizon, (4) target IRR, (5) risk tolerance.
**Stabilized multifamily, institutional sponsor, 10-year hold:** 75% agency senior + 10% agency pref equity + 15% sponsor equity. Low cost of capital, high LTV, non-recourse.
**Value-add multifamily, middle-market sponsor, 5-year hold:** 65% bridge senior + 15% mezz + 20% sponsor equity. Higher cost of capital but matches transitional deal profile.
**Owner-operator hotel, SBA 504 eligible:** 50% bank first + 40% CDC second + 10% sponsor equity. Lowest sponsor equity in all of hotel CRE but requires owner-operator structure + full guarantee.
**New-construction hotel, institutional sponsor:** 60% construction senior + 15% mezz + 25% sponsor equity. Higher risk profile → higher cost across the stack.
**Data center with hyperscaler anchor:** 65% senior construction-to-mini-perm + 15% mezz + 20% sponsor + JV pref equity. Integrated full stack managed by firms like Ares or KKR.
The key insight: there's no 'optimal' stack — the right stack depends on the specific deal. PeerSense designs stacks first, then matches each layer to the right capital source.
Frequently Asked Questions
What is a capital stack?+
A capital stack is the arrangement of different types of capital funding a commercial real estate or business acquisition transaction, ordered by priority in default. Typical structure from bottom (paid first) to top (paid last): senior debt (60-75% LTV), mezzanine debt (15-20%), preferred equity (variable), and sponsor common equity (10-25%). Each layer prices differently based on risk: senior 6-9%, mezz 11-15%, pref equity 11-18%, common equity 15-25%+ IRR.
Why does the capital stack matter?+
Capital stack design directly determines: (1) how much equity the sponsor commits, (2) whether the deal cash-flows during the hold, (3) what IRR the sponsor achieves at exit, (4) what happens in a downturn. A poorly-designed stack kills otherwise-strong deals; a well-designed stack can make marginal deals work. Capital stack design is the single most-important decision made before signing an LOI.
What determines order of payment in default?+
Legal structure determines payment priority. Senior debt holders (first mortgage) get paid first from any liquidation. Mezzanine debt (UCC pledge of equity interests) gets paid next. Preferred equity gets paid after all debt, before common equity. Common equity is last — often recovers nothing in distressed sales. Intercreditor agreements formalize the waterfall among lenders.
Can I skip mezzanine and use only senior + equity?+
Yes — many deals use only senior debt + sponsor equity. The trade-off: higher sponsor equity commitment. On a $10M deal with 65% senior, skipping mezz means sponsor commits $3.5M equity instead of $2M (with 15% mezz filling the gap). Skipping mezz makes sense when: sponsor has excess equity to deploy, the deal's unlevered return is below mezz cost, or senior lender requires more equity for approval.
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Editorial integrity: Published by PeerSense Capital Advisory · Written by Ed Freeman, Founder. PeerSense is a capital advisory firm, not a lender. Content is for educational purposes and does not constitute financial, legal, or tax advice. Rates and terms cited reflect approximate April 2026 market conditions and may not reflect current conditions at the time of reading. Consult a qualified financial professional for transaction-specific guidance.