A practical guide to layering senior debt, mezzanine financing, preferred equity, and common equity for a commercial real estate transaction.
Understanding how to structure the capital for a commercial real estate transaction is one of the most important skills a sponsor can develop. The capital stack determines your cost of capital, your risk exposure, your flexibility during the hold period, and ultimately how returns are distributed when you exit.
This guide explains each layer of the capital stack, how lenders and equity partners evaluate their position, and how to sequence your capital raise before approaching the market.
The capital stack is the layered structure of financing used to fund a commercial real estate investment. Each layer represents a different source of capital with a different risk profile, cost, and priority of repayment.
From lowest risk to highest risk, the four primary layers are:
The order matters because it determines who gets paid first in a distribution and who absorbs losses first in a default. Lower layers have priority. Higher layers carry more risk and demand higher returns to compensate.
Before approaching any capital source, establish the full cost of your transaction:
This total project cost becomes the denominator for your leverage calculations. Every lender in the stack will underwrite to this number.
Senior debt is the foundation of every capital stack. It sits in the first lien position, carries the lowest risk, and therefore offers the lowest cost of capital. You size and price your senior loan before anything else because all other layers are subordinate to it.
Senior lenders evaluate three primary metrics:
Loan-to-Value (LTV): The ratio of the loan amount to the appraised value of the property. Stabilised assets typically support higher LTV; transitional assets support lower LTV due to execution risk.
Loan-to-Cost (LTC): Used for construction and value-add transactions. The ratio of the loan to total project cost. Most senior construction lenders operate within defined LTC limits depending on property type and market.
Debt Service Coverage Ratio (DSCR): Net Operating Income divided by annual debt service. Permanent lenders require a minimum DSCR to ensure the property generates sufficient income to cover the mortgage. Bridge lenders often underwrite to a stabilised DSCR rather than current income.
Once you know your senior loan amount, subtract it from your total capitalisation requirement. The result is your equity gap: the amount of capital that must come from sources other than senior debt.
Total Project Cost minus Senior Loan Amount equals Total Equity Required
From here you have two choices: fund the entire equity gap with common equity, or introduce subordinate capital (mezzanine or preferred equity) to reduce the amount of common equity required.
The decision depends on your return targets, your equity investors' expectations, and the availability of subordinate capital in the current market.
Mezzanine debt and preferred equity sit between the senior loan and common equity in the capital stack. Both allow sponsors to achieve higher total leverage, reducing the amount of common equity required and potentially improving returns on invested equity.
Mezzanine debt is secured by a pledge of the ownership interests in the borrowing entity rather than a mortgage on the property. It is subordinate to the senior loan and sits above common equity.
When to consider mezzanine:
Key mezzanine considerations:
Preferred equity occupies a similar position in the capital stack to mezzanine debt but is structured as an equity investment rather than a loan. It is not secured by a pledge of ownership interests and has different enforcement rights in a default scenario.
When preferred equity is used instead of mezzanine:
The choice between mezzanine and preferred equity is often determined by what the senior lender permits, the tax structure of the transaction, and the preferences of the capital provider. In practice, both achieve a similar result: additional capital above the senior loan at a cost between senior debt and common equity returns. See our detailed comparison of mezzanine debt vs. preferred equity for more.
Common equity sits at the top of the capital stack, carries the most risk, and expects the highest return. It absorbs losses before any debt layer and is the last to receive distributions.
In most institutional transactions, common equity is structured as a joint venture between an operating partner (sponsor) and a capital partner (institutional investor, family office, or high-net-worth partner).
Preferred return: The minimum annual return the equity partner receives before profits are split. This is paid from cash flow and/or sale proceeds before the sponsor participates in upside.
Equity multiple target: The total return on invested capital the equity partner expects over the hold period, expressed as a multiple of invested equity.
IRR hurdle: The Internal Rate of Return threshold above which profit splits change. JV structures typically have multiple IRR hurdles with increasingly favourable splits to the sponsor as performance improves.
Promote (carried interest): The disproportionate share of profits the sponsor earns for managing the deal and creating value above the return hurdles.
Decision rights and control: Who controls major decisions, including refinancing, lease approval, capital expenditure above a threshold, and sale timing.
These terms are negotiated in the joint venture agreement and have significant economic consequences. Sponsors should model multiple return scenarios before committing to specific hurdle rates.
Before approaching any capital source, map the full stack on paper. Confirm that:
Approaching senior lenders before knowing your equity plan. Senior lenders will ask about your equity source. Arriving without a clear answer signals inexperience and slows the process.
Assuming all senior lenders permit subordinate financing. Many do not. Confirming this before building your stack saves significant time.
Optimising for leverage without modelling the cost. Higher leverage improves returns in a good scenario and amplifies losses in a bad one. Model both.
Negotiating equity terms without understanding the promote mechanics. Sponsors sometimes agree to promote structures that are difficult to achieve in practice. Model realistic return scenarios before committing.
Presenting a capital stack to lenders that has not been stress-tested. Lenders will stress your assumptions. Arrive having already done it yourself.
Mezzanine debt is a loan secured by a pledge of the ownership interests in the borrowing entity, sitting between the senior mortgage and common equity. Preferred equity is structured as an equity investment with priority return rights. Both occupy a similar position in the capital stack and achieve similar results, but they differ in security, enforcement rights, and tax treatment. The choice is often determined by what the senior lender permits and the preferences of the capital provider.
Senior loan sizing is driven by three constraints: LTV (loan-to-value), LTC (loan-to-cost) for construction deals, and DSCR (debt service coverage ratio). The binding constraint varies by lender and transaction type. A stabilised multifamily property might be LTV-constrained by an agency lender; a value-add office deal might be DSCR-constrained by a bank. Understanding which metric limits your loan size requires running all three calculations and taking the lowest result.
Many sponsors fund equity from their own balance sheet or a pool of existing investors. Whether you need an institutional JV partner depends on the size of the equity requirement, your available capital, and your investors' preferences. Institutional JV equity is typically used for transactions where the equity requirement exceeds what the sponsor can fund from existing relationships, or where an institutional partner adds credibility with senior lenders.
In most cases, no. The intercreditor agreement between the senior lender and mezzanine lender must be in place at closing or shortly thereafter. Adding subordinate financing after senior loan closing typically requires the senior lender's consent and involves significant legal work. It is far easier to structure the full stack before closing.
Timeline depends on the complexity of the structure and the number of capital sources involved. A straightforward senior debt transaction can close in 30 to 60 days. Adding a mezzanine or preferred equity layer typically adds 2 to 4 weeks for intercreditor negotiation and additional due diligence. A full JV equity raise with an institutional partner can take 60 to 90 days from first conversation to closing. Sequencing matters: start with senior debt and equity simultaneously rather than sequentially.
George Smith Partners structures and arranges capital across every layer of the stack, from senior bridge and construction loans through mezzanine, preferred equity, and JV equity. Our team has closed transactions across all major property types and markets nationally.
Discuss Your TransactionThe financing structures, leverage ranges, and return thresholds described in this article are intended for educational purposes and reflect general market conditions at the time of publication. Actual terms vary by transaction, lender, market conditions, sponsor profile, and property type. Nothing in this article constitutes a commitment to lend or a guarantee of specific terms. George Smith Partners recommends consulting directly with our team to assess the appropriate capital structure for your specific transaction.